Earnings Call: Q1 2016

Apr 26, 2016

Summary

Adjusted net income was $348M, excluding a $943M European Commission charge that drove a reported $595M net loss. Truck margins remained strong, with slightly higher Q2 deliveries expected and FY gross margin guidance of 14.5%-15%.

Good morning, and welcome to Paccar's first quarter 2016 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. Joining me this morning are Ron Armstrong, Chief Executive Officer, Bob Christensen, President and Chief Financial Officer, and Michael Barkley, Senior Vice President and Comptroller. As with prior conference calls, if there are members of the media on the line, we ask that they 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 good revenues and excellent operating income for the first quarter of 2016. Paccar's first quarter sales and financial services revenues were $4.3 billion, and first quarter adjusted net income, a non-GAAP measure, was $348 million, an 8.1% after-tax return on revenues. Adjusted net income excludes a $943 million non-recurring charge for the European Commission investigation of all European truck manufacturers. Including the non-recurring charge, Paccar reported a net loss of $595 million in the first quarter. Paccar achieved excellent truck parts and other gross margins of 14.9%, helped by the strong European truck market. I am very proud of our 23,000 employees who have delivered industry-leading products and services to our customers worldwide. Paccar delivered 35,300 trucks during the first quarter, in line with our expectations. Deliveries in Europe were over 30% higher than last year's first quarter. Looking ahead, we expect a slight increase in deliveries in the second quarter compared to the first quarter. Second quarter gross margins are projected to be comparable to the strong first quarter margins, reflecting the benefits of DAF, Peterbilt, and Kenworth's new truck models, the benefits of steady build rates, good truck markets, and continued material cost savings. Paccar's forecast for Europe's greater than 16 ton market is a range of 260,000-290,000 units, reflecting strong demand and a steady economic outlook. Europe's GDP growth expectations for this year are 2% in the U.K., which is DAF's largest market, and 1.5% on the continent. Freight transport activity on German highways in the first quarter was up 4% over the same period last year. Year to date, DAF has achieved a record 16.6% share of the heavy duty market. The economic picture in the U.S. remains positive. With GDP forecast to grow 2.1% this year, the housing and automotive industries create a large amount of freight. Housing starts are projected to grow 11% this year to over 1.2 million, and the automotive industry is expected to deliver 17.5 million vehicles, which would be a record. Other positive signals are that the ISM Manufacturing Index has returned to expansion, and manufacturing inventories in the economy appear to be stabilizing. We estimate U.S. and Canadian Class 8 truck industry retail sales will be in a range of 220,000-250,000 units this year, the third best in the last decade. The economy's steady growth is supportive of healthy freight levels. The ATA Tonnage Index continues at record levels. Peterbilt and Kenworth's combined retail sales market share of the U.S. and Canadian market is 26% year to date. Our share of net orders so far this year is strong at 37%, as customers appreciate the benefits of Kenworth and Peterbilt's reliable and fuel-efficient trucks and industry-leading resale values. Paccar's parts business generated quarterly revenues of $720 million compared to $753 million in the same quarter of last year. Paccar Parts' quarterly pre-tax income was $135 million, an excellent return on revenue of 18.7%. These results were driven by good fleet utilization, the growing number of Paccar trucks and engines in operation, and the many innovative products and services offered by Paccar Parts and our dealers. Paccar Financial Services' first quarter pre-tax income was $80 million compared to $89 million a year ago. Excellent portfolio performance contributed to the good results. Paccar's strong balance sheet and positive cash flow have enabled the company to invest $3.3 billion in new products and facilities in the last five years. Paccar's capital spending of $325 million-$375 million this year is targeted at enhanced aftermarket support, manufacturing facilities, and new product development. Research and development expenses are estimated to be in a range of $240 million-$260 million. Paccar continues to enhance its leadership position in the global truck market by developing the highest quality products and services in the industry. Thank you, and I'd be pleased to answer your questions. Operator? Your first question comes from the line of Jamie Cook. Hi. Good morning. Good morning. In the nice quarter. Thank you very much. I guess, couple questions. The gross margins in the first quarter were higher, I think, than you expected and then relative to what the Street expected. Can you just talk through, because the Q isn't out yet, how much of that was material cost, how much of that was benefits from increasing production? I also think last quarter you alluded to being able to achieve flat gross margins year-on-year. Can you talk about your comfort level with that today versus where we sat last quarter with material costs potentially being a headwind in the back half of the year? Sure. With the pricing environment. Sure. First quarter, we had an excellent quarter from an execution standpoint. Our plants had steady build rates, as I mentioned, and able to operate the plants very efficiently during the quarter, continue to see favorable benefits from some of the material cost movement that our purchasing and materials teams are providing with our suppliers, working closely with them to provide good value for our customers. The products are performing great in the field, so we've seen a good performance in our warranty costs during the quarter. All the elements, just a good quarter of execution provided the results that we've seen. As we look forward for the full year, margins, I think, will still be in that 14.5%-15% range for the full year at these build rates. We'll continue to operate at the kind of levels that we saw in the first quarter, I believe. I'm sorry, can you just also, and I'll get back in queue, comment, last quarter you talked about your inventory levels being at a much healthier rate relative to your peers. Can you just provide an update on that? I think the same situation exists. Our inventories are below 60 days in the field, and so in great position. So what we produce will find its way to the customers' hands. Okay, great. I'll get back in queue. Thank you. Thank you. Your next question comes from the line of Alex Potter with Piper Jaffray. Hi, guys. Maybe just to follow up on that question, the initial question there on gross margin. Can you comment on pricing, if you've been seeing any sort of funny business with pricing given the inventory buildup at other OEMs in the channel? No, I'd say, pricing is pretty steady in the marketplace, and that's what we experienced in the first quarter. Okay, very good. Was wondering also if you could comment a little bit on your outlook for areas other than North America and Europe. So Brazil, obviously, but also the rest of South America, Mexico, Australia, any of the other regions that you sell a material amount of trucks into. Yeah. First, talk about Australia and Mexico. I'd say the markets there are good, they're steady, and our plants out there also operated very efficiently during the quarter and markets are pretty reasonable. Brazil, the country is challenging, but we continue to move forward with our business. Build rates are steady, and the team is doing an excellent job of continuing to establish the, deepen the footprint of DAF in the marketplace. We continue to see pretty good activity with respect to the Andean countries in South America with both the Kenworth and DAF brands. Okay. Thank you. Thank you. Your next question comes from the line of Ann Duignan with JP Morgan. Hi, good morning. This is Mike Conman on for Ann. Good morning. I just wanted to get a little bit of color on the financial services margin was a little bit weaker than expected, and if there was any particular reason why that may happen or may continue. Well, one of the things that we saw late last year, first quarter this year, there's several of our competitors have a pretty sizable oversupply of used truck inventories, and that has dampened the overall market prices. So, whereas last year in our financial services business, we had nice used truck gains. This first quarter this year, those used truck gains didn't repeat. So it's primarily used trucks, a little bit of impact of currency movement, but primarily the effects of used truck pricing. Okay. Thank you. Sure. Your next question comes from the line of David Leiker with Robert W. Baird. Hi, this is Joe Vruwink for David. Morning. I was wondering if you could give your European order growth in the quarter. When I just look at what individual countries are doing, it would seem like DAF in the quarter with over 30% growth is doing quite a bit better than just what the U.K. and Netherlands markets might be doing. Are you gaining market share of countries that might have not been typically DAF countries in the past? Yeah, I think in most countries, DAF gained share year-over-year on the quarter perspective. The Euro 6 product that DAF has had in the market now for a couple of years is performing excellently, and the fuel efficiency, the reliability of the product is the best it's ever been. As time goes on, more and more customers are recognizing that. When you look at some of the southern markets that have been pretty depressed for quite a few years, those are recovering. DAF has a strong presence in Central Europe and countries like Poland, Czech Republic, Hungary, and many of those is number one or two in those markets. I think just the combination of all those elements coming together, DAF achieved 16.6% share for the first quarter, which is a record level for them. It's really across the continent. Okay, and similar conversation, but here in the U.S., to get 37% share of incoming orders, I think your Class 8 retail is closer to 25% right now. Is that particular vocations maybe, or regions of the country where you're just more positioned relative to the other OEMs, or is it similar in that new product is driving the gains? Yeah, I think new product is the big thing. The Peterbilt 579, 567 models and the Kenworth T680 and T880 models are very well received by the customers. The Paccar engine penetration increased to 46% in the quarter, so there's more and more acceptance of the Paccar engine in the product. Just the continued appreciation of the product, the fuel efficiency, the reliability of the current products is excellent. Great. I will hop back in queue. Thank you. Thank you. Your next question comes from the line of Steven Fisher with UBS. Thanks. Good morning. Good morning. You just want to follow up on the cost savings. I know you mentioned continuing material cost savings expected in Q2. I guess given the rise we have seen in commodity prices, how is that baked into your expectation to the 14.5%-15% margins for the full year, and I guess particularly in the second half? Well, we have long-term agreements with most of our suppliers, which tend to smooth out both the upticks and downticks in material cost movements from a commodity standpoint. So, it will be pretty muted in terms of any uptick that we might see and how that might play into our costs and pricing. Do you think you can get pricing benefits on top of the higher costs as the smoothing sort of works itself through over the course of the year? You typically do. It may not be exactly at the same time, but typically those things find their way to the marketplace. Okay. Then just on the FinCo earnings, wanted to clarify what it was within the interest and other that drove the higher cost. I am not sure if that was the used pricing that you were talking about earlier. Do you think the 10% year-over-year decline in profit is going to be better, worse, or the same as what the full year could be? A lot will depend on how the used truck market develops in the coming quarters. We will see how that develops. In terms of the interest and other, part of that is just a larger portfolio. The average earning assets in the first quarter of this year are higher, and so that just reflects we have higher assets and higher debt levels that go with that, and that just reflects the higher costs that go with it. Okay. Thank you. Thank you. Your next question comes from the line of Jerry Revich with Goldman Sachs. Hi. Good morning, everyone. Morning, Jerry. Ron, I wonder if you could talk about the pricing environment in Europe specifically. You folks have spoken about once the market gets good enough, you might be at a point where you get to make a margin on the new emissions components. Are we at that point yet? Can you just give us an update within the context of the steady pricing environment that you outlined across the business? Yeah, I wish that were the case, Jerry, but pricing is pretty steady, in terms of this year versus what we saw last year during the course of the year. Market is good, so pricing environment has been, as I said, pretty steady without much up or down movement. Okay. Can you talk about what you're seeing out of your customers in terms of parts consumption in North America? It looks like your North America parts business may have been down more than the overall parts business. Is that an issue of timing, or what drove that? I think we're hearing from construction industries that it was a pretty seasonally positive quarter for business. I'm wondering if you could just fill in the gaps on what you're seeing out of your customers there. Yeah. So from a customer standpoint, the actual retail sales at the dealer level were up a bit during the quarter. What we saw was the dealers rebalancing their inventories to sort of adjust to individual local market conditions. So we expect that we'll see in the second quarter and beyond, an improvement in parts sales for the rest of the year. Okay. Lastly, you've done a nice job bringing down warranty costs on Euro VI engines. I'm wondering if you could just update us on how that's tracking. Did that warranty accruals continue to decline sequentially based on the experience level, or are we at the run rate based on the actual warranty instances that you're seeing? Yeah. The DAF trucks, the Paccar engines, the Kenworth Peterbilt trucks around the world are performing very well. Best reliability, I think, in the industry. We've seen that reflected in our warranty provisions quarter-over-quarter. The first quarter was at a good run rate that we think is appropriate for our product. Okay. Thank you. Thank you. As a reminder, to ask a question, that is star one. Your next question comes from the line of Ross Gilardi with Bank of America. Hi, good morning. Thank you. Good morning. I was wondering if you could just talk a little bit about your internal engine effort. Obviously Paccar has been targeting a 50% make versus buy in North America for a long time. You've been inching closer to that target. I'm just wondering, any reason why you would stop at 50%? If you were to go beyond 50%, would you need to go all the way to 100% to justify the capital investment, or could we see that target just slowly be dragged higher? The wonderful thing about our facility in Columbus, Mississippi, we built it at 400,000 sq ft. We're continuing to add additional equipment into the facility to achieve what's possible within that footprint. We have 400 acres of land, and it's expandable just as we had planned it to be. So we're earning a strong return off of the investment that we have made, and we'll continue to make additional investments as the engine penetration grows in North America. The 50% is sort of a short midterm target. The longer term target, as we look at our customers and the applications they have, we feel the engine can meet up to 80%-85% of customer needs. So that's sort of the target at this point longer term. We'll continue to invest to increment capacity as we need it, and we'll be making some of those investments in the next couple of years to support the growing acceptance of the engines. Doing great. Okay, thanks. What about your vertical integration effort in other product categories? I think at one of your more recent investor days, you had talked about things like axles also that you can make internally. Are you doing more of that? Is that a driver of success in the gross margin? Well, DAF has been making axles for the 20 years that Paccar has owned them, and that's what you get when you order a DAF truck, our Paccar axles. In North America, we're looking at opportunities to take advantage of DAF's axle technology and capabilities. We have great working relationships with Dana and Meritor, who are providing really customized applications that integrate well with the rest of the Paccar powertrain, to be able to offer our customers the unique capability of a fully integrated powertrain to operate their vehicles. Thank you very much. Thank you. Your next question comes from the line of Seth Weber with RBC Capital Markets. Hey, good morning, everybody. Morning, Seth. Appreciate the color on the Europe market. We've been hearing some discussion about some rising dealer inventories in Europe. I'm wondering if you've seen anything there with just across the industry or with DAF specifically. Yeah, we don't have any visibility to the industry as a whole, but I will tell you, DAF's inventory is in great shape. Very similar to what we see with Peterbilt and Kenworth in North America in the 45-60 day range, which is really optimal to meet customer demand and not have excess inventories on the ground. Okay. Thank you. If I could just go back to the parts business for a minute. I know in prior quarters, FX has been a headwind there. Was it a headwind here in the quarter, and are you still expecting kind of a low to mid-single digit growth for the parts business this year? I guess just separately, could you give us what FX impact was for the company for revenue and operating income altogether? For the parts business, we're getting pretty close now where foreign exchange rates have been pretty comparable with a little bit of effect on revenue. I think it was $10 million in the parts business in the first quarter. I'll let Michael sort of comment on the overall effects for the company. Yeah. For the truck parts and other net sales and revenue impact was $68 million. The impact on financial services revenues was $9 million, and the impact on profitability was negligible. Okay. Just, sorry, on the parts outlook for the year, is sort of low to mid-single digits still the right way to think about it, or how you are thinking about it? Yeah, I think we will see a return to growth as we progress through the year. I think parts sales globally could be up towards the 3% range for the year. Terrific. Thank you very much. Thank you. Your next question comes from the line of Joe O'Dea with, I'm sorry, Joe O'Dea with Vertical Research. Hi, good morning. Morning, Joe. Just a question relative to the order share. We do not typically see those kinds of swings then translate into retail sales. But given that kind of order magnitude, do you think that that creates any more volatility over the course of the year, or based on the timing of when those orders are scheduled to ship, would you not see any kind of disruption? No, I do not think the orders create any additional volatility. They just bolster the backlog. I think because we build the truck when we have an order, we do not build for inventory. We prudently manage our build schedule, and so the fact that we had 37% of the order just reflects that we have got customers really appreciating the vehicle and ordering for what they need for the coming couple of months. Okay, and do you have kind of a targeted share where you think your share will be in U.S. and Canada for 2016? Well, I think On retail? Yeah. Last year we were 27.5%, so I think we'll be slightly above that for the full year in terms of retail sales. Great. Thanks very much. Sure. Your next question comes from the line of Adam Uhlman with Cleveland Research. Hi, good morning, guys. Morning, Adam. I guess, first, a clarification, I might have missed it, but did you mention the magnitude of used truck pricing that you are seeing right now? If not, could you tell us kind of what that trend has been looking like recently, and when you would expect to see a stabilization in used truck prices? I think we are starting to see a stabilization during the quarter from the, say, fourth quarter into the first quarter. It was probably a 5%-10% impact for the market as a whole. The good news is that the Peterbilt, Kenworth, and DAF products continue to maintain their premium relative to the competition in the 10%-20% range. Okay, got you. Back to the share of orders that you got in North America. Congrats on pulling those in. Could you tell us what the first quarter of last year's share was, or what the year-over-year order growth was for you? I don't think we have that number readily at hand, so we'll have to come back to you on that. Okay. The record share at DAF, you had mentioned that there was a good breadth of strength in share across the continent. Yes. I'm wondering if you believe that directionally, that this level of retail share can persist for the rest of the year. DAF in 2012, 2013 was in the 15.5%, 16% range. Yes, I believe this is probably more consistent. We had some interruptions, if you will, with the Euro V, Euro VI transition, and I think this is more indicative of DAF's position in the market. Got you. Thank you very much. Thank you. Your next question comes from the line of Mike Shlisky with Seaport Global. Good morning, guys. Morning. In your release, you actually mentioned you were going to be expanding your Denton facility in the near future to expand the capacity there. I guess I was kind of wondering, this past year was a very, very strong year for Class 8 in 2015, and I don't think you had too many problems delivering to your customers. I guess, what's being expanded at Denton that's so important, and when can we start seeing some of the margin benefits from that expansion? Well, you'll see the margin benefits whenever we get it finished and we're utilizing the facility. But as you go through the cycles, you identify opportunities to continue to make your facilities and your processes more capable. This is just sort of the continuing effort that we go through and have gone through for 110 years of the company of continuing to invest during all phases of the business cycle, to be able to be prepared, one, to get the efficiencies, but also to get that incremental capacity. The penetration of the 2.1-meter products both at Peterbilt and Kenworth, that's been outstanding, and we continue to invest in the robotic capacity in those facilities. This is just part of that overall process that we go through throughout our history of making good, prudent investments that prepare us not only for today, but also for tomorrow. So it's more efficiency gains, and it's not intended to substantially increase the number of trucks you can make in a year, you can just make them faster or better? It's a combination of both. Okay. Just one quick, mild question for you as well. Could you give us the diluted share count adjusted if you had not posted a loss for the quarter? It would've been 351.9. Okay, perfect. Thanks, guys. Appreciate it. You betcha. Your next question comes from the line of Robert Warthimer with Barclays. Hi, thanks for the commentary. Great results. Thank you. Are you able to talk just a little bit about how you're approaching the 11 liter launch and any numbers you're willing to update on the penetration in Europe and the U.S.? Yeah, so the MX-11, as you know, we've launched that in Europe in the fourth quarter of 2013, has been very well received, in Europe by both our truck customers as well as, we sell several thousand engines each year to bus and coach customers, and that has become the engine of choice of those bus and coach customers, for their applications. So, two years of experience in Europe and launched it in January this year in North America, and the launch has gone very well. I was recently on a trip visiting with some of our customers, and there's a lot of interest by a lot of different types of customers, particularly those that are sensitive to weight, because it's 400 pounds lighter than our other offering. It's a very attractive option. The launch has gone good. The customers who have put that into their product, early days, it's performing as expected and we'll continue to ramp that up as we progress through the course of this year. That's perfect. Did you launch it in many models at once, or is it just sort of a stage thing where we can expect it to take a couple of years to be fully out there in the fleet? No, it will be a stage. We are purposefully ramping up both the plant so that they get more comfortable with the assembly process. But the early days is very promising. Great. Thank you. Thank you. As a reminder to ask a question, that is star 1. Okay, there are no other questions in the queue at this time. Are there any additional remarks from the company? We'd like to thank everyone for their excellent questions. Thank you, operator. Ladies and gentlemen, this concludes Paccar's earnings call. Thank you for participating. You may now disconnect.