Earnings Call: Q2 2015

Jul 28, 2015

Summary

Record Q2 net income reached $447 million, up 40% YoY, with strong margins driven mainly by operating leverage. Truck production was expected to ease 1%-2% in Q3, while full-year market forecasts rose in Europe and North America.

Good morning, and welcome to Paccar's second quarter 2015 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, Vice President Controller. 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 record quarterly net income of $447 million for the second quarter of 2015. Net income increased 40% compared to the results generated in the second quarter last year. Paccar's second quarter sales and financial services revenues were $5.1 billion. Gross margins for truck parts and other operations were strong at 15.1%. The excellent margins, coupled with the company's rigorous cost control, generated 8.8% after-tax return on revenues. I am very proud of our 24,500 employees who have delivered industry-leading products and services to our customers worldwide. Paccar delivered 41,600 trucks during the second quarter, an 8% increase versus the first quarter of this year and slightly ahead of our expectations. The improvement reflects increased truck deliveries in North America and Europe due to economic growth and strong freight demand. Looking ahead, we expect Paccar's global truck deliveries in the third quarter to be slightly lower compared to the second quarter, reflecting the normal summer factory shutdown for DAF and Leyland. Third quarter gross margins for the truck segment will be impacted by a higher percentage of deliveries to large fleets and the summer shutdown in Europe. The European economic and truck market outlook continues to improve. GDP growth expectations for this year are 2.4% in the U.K., which is Paccar's strongest market in the region, with 1.5% GDP growth on the continent. Freight transport activity on German highways is up 2.6% year-to-date through June compared to the same period last year and is at the highest level since the German toll system was launched in 2007. DAF heavy truck order intake for the second quarter was 60% higher than a year ago. We've raised our forecast for Europe's greater than 16-ton market to a range of 240,000 to 260,000 units, reflecting the strength in orders and the improved economic outlook. DAF's heavy truck market share is 15% year-to-date. The U.S. economic picture remains positive, with GDP forecast to grow 2.4% this year. The housing and automotive industries are bright spots in the economy and create a large amount of freight. Housing starts are projected to grow 11% this year to 1.1 million, and the automotive industry is expected to deliver 16.9 million vehicles, near the record level of 17.3 million set in the year 2000. U.S. freight tonnage is at near record levels. We've raised our U.S. and Canadian Class 8 truck industry retail sales estimate to a range of 270,000 to 290,000 units this year. The stronger market reflects expansion in industry fleet capacity due to continued strong freight fundamentals. Peterbilt and Kenworth's combined share of the U.S. and Canadian market is 28% year-to-date. Paccar's Parts business generated record quarterly pre-tax profits of $146 million, a 15% increase compared to $127 million in the same quarter of last year. The strong results were driven by economic growth in the U.S. and Europe and the many innovative products and services offered by Paccar Parts and our dealers. Paccar Parts revenue was $777 million, compared to $778 million achieved in the second quarter of 2014. Excluding the effects of foreign currency translations, parts revenue would have been up 7% for the second quarter and first six months of this year. Paccar Financial Services' second quarter pre-tax income was $91 million, compared to $92 million earned a year ago. Foreign currency translation reduced profit by $4 million for the quarter. The portfolio continues to grow and perform well. Paccar's strong balance sheet and positive cash flow have enabled the company to invest $5.9 billion in new products and facilities in the last 10 years. Our outstanding results this year reflect the quality of those investments. Looking forward, Paccar is well-positioned for future growth with further investments in geographic expansion, aftermarket parts and service capabilities, and powertrain and truck technologies that increase fuel efficiency, safety, and reliability. This year, Paccar's capital spending of $325 million-$375 million is targeted at enhanced powertrain development and increased operating efficiency of our assembly and distribution facilities. Research and development expenses are estimated to be in a range of $225 million-$250 million. Paccar's technology leadership has been enhanced as Kenworth TruckTech+ and Peterbilt SmartLinq remote diagnostic systems are now in production on new Kenworth and Peterbilt Class 8 trucks specified with the PACCAR MX-13 engine. DAF plans to launch its connected truck technology in the fourth quarter of this year. In addition, Paccar Parts has begun construction of a new 176,000 square foot distribution center in Renton, Washington. We expect this distribution center to open in mid-2016. DAF's cab factory in Westerlo, Belgium, plans to begin construction of a new cab paint facility this year. This environmentally friendly paint facility will increase DAF's production capacity and utilize the latest robotic technology to improve operating efficiency. Paccar's board of directors approved a 9% increase in the regular quarterly dividend to $0.24 per share at its July meeting. The company has increased the regular quarterly dividend by more than 165% in the last six years. Paccar continues to enhance its leadership position in the global truck market by developing the highest quality products and services in the industry and providing excellent returns to its shareholders. Thank you, and I'd be pleased to answer your questions. Ladies and gentlemen, if you would like to ask a question at this time, simply press star then the number one on your telephone keypad. Again, if you would like to ask a question, please press star then the number one. The first question comes from the line of Ann Duignan with JP Morgan. Hi, guys. It's Ann Duignan. Good morning, Ann. No, afternoon from here. Okay. Let's see. I guess I was interested in, you talked about investments in powertrain capabilities this year and going forward. Can you just give us a little bit more detail on what specifically you are investing in? It's all about operating efficiency and being the leader in providing that to our customers to reduce their operating costs. That's a continual stream of investment in research and development, as well as capital to support those initiatives. We've got greenhouse gas requirements coming into play in 2017 and additional requirements beyond that. We'll just continue to make those investments to support our customers. Okay. On European outlook, can you talk about your revised outlook versus the very strong registrations we've been seeing year to date, particularly in June? Well, our revised outlook reflects those strength in those registrations as well as the strength of the DAF order intake. We see that there could be some further upside potential as the year progresses, but as we see it now we see that that 10% improvement is certainly achievable, so there could be some upside from there. Where specifically do you think the upside could come from? Is it Germany, U.K., or some of the weaker southern countries that are just coming from zero, basically? I think we've seen general improvement across all the markets. Some a little bit more than others, but general improvement across all. Okay. I'll leave it there and get back in line. Thank you. Thank you. Our next question comes from the line of Jerry Revich with Goldman Sachs. Good morning and good afternoon, everyone. Good afternoon, Jerry. Ron, I am wondering if you could just bridge the margin performance for us in the quarter, either year-over-year, sequentially at the gross margin line. Any specific significant items that you will highlight, pricing versus cost, any other factors that you could just maybe help us understand the pretty significant expansion on both year-over-year and sequentially? Well, as you know, we have always maintained a healthy discipline of rigorous cost control, and we continue to do that. I think the operating leverage is the single biggest factor that we have seen contribute to our margin performance over the last 12 months and quarter-over-quarter. Other positive things include some positive effects of materials and pricing, but those are muted compared to the operating leverage. Okay, thank you. For the Paccar Parts business, the 7% organic growth in the quarter, can you flesh out for us whether Europe was above or below that and any color that you can give us from a mix standpoint? I think this is the second or third quarter in a row in which parts mix was favorable to you folks. Can you just talk about what is driving that? Oh, the parts team has done a great job of continuing to build its programs, and it is expanding its all makes products capability for both trucks, trailers, buses, et cetera. We continue to see nice growth in that business. We really saw it spread pretty evenly across all of our geographies, both North America, Europe, and around the world. Okay, thank you. Lastly, in Europe, can you tell us what the book to bill was in the quarter or how much lead times lengthened as a result of the orders just put the 60% order growth into context relative to production in the second quarter, if you don't mind. Well, again, we don't think in those terms generally, but the backlog is very healthy and supports our expected plans to increase our build rate during the second half of this year. Okay. Thank you. Thank you. The next question comes from the line of Joe O'Dea with Vertical Research. Hello. First question may be more specifically on the margin and looking at the truck segment, because that seemed to be the strongest performer between truck and parts and a very strong sequential incremental margin there. I think you did talk a little bit about maybe some customer mix that was a benefit. Anything else in the quarter, and then how we should think about the back half of the year margin in the truck segment, whether 2Q is a good benchmark or some of the shifts that might happen to bring that down? As I mentioned in my comments, we expect that the third quarter will be impacted by a little heavier fleet mix in the third quarter as well as the normal factory shutdown that we have in Europe. So some leverage effects related to that. Okay. But other than that, nothing else specific in the quarter to get a 10.5% margin. Nothing unusual in the second quarter. We don't have any expectations for any unusual items in the third quarter. Okay. Then in North America on sort of vocational demand, any sort of weakening that you've seen in those markets related to oil and also just with respect to your backlog, did you see any sort of higher activity in terms of cancellations in the quarter? No. Cancellations have been at a very low rate, and vocational trucks are very active. Lots of reasonable growth in housing construction, commercial construction. So it's all been pretty steady. Okay. Thanks very much. Thank you. The next question comes from the line of Patrick Nolan with Deutsche Bank. Good morning, everyone. Good morning. Two questions. The first, can you just discuss what you're seeing as some of the pricing dynamics both in North America and Europe? I think pricing is reasonably consistent. We have great products. The Peterbilt, Kenworth, and DAF teams pretty much have new product lines that are in the field over the last 1-2 years, and those have been very well received. We continue to invest in fuel efficiency of our engines, the aerodynamics of our vehicles, and all those elements are very well received by our customers. Good value, and so continue to achieve premium pricing for our products. The outlook is bright as we continue for the rest of this year and into next. Second question. Very strong margin performance in the quarter, but some of your suppliers have actually said running at this pace of production for the industry, there's inherently some inefficiencies that go along with that. Do you see that? When you think about next year's volume outlook, even if volume's off a little bit, do margins still go up in North America, or is this kind of a really good operating environment in your opinion? I think it's a really good operating environment. I think we're in a good position right now. Obviously our teams and our factories do a great job of managing to the conditions in the marketplace, and we expect that that will continue as we move forward the rest of this year and next. I'd just add that the rate of increase in production over the last several quarters has been relatively modest and has allowed the suppliers to lay in capacity and efficiency improvements in an orderly way, and they're performing very well. Can I just sneak in one more? What percent more of your Class 8 volume was the internal Paccar engine? It's about 40%. All right. Thanks very much. I'll get back in the queue. Thank you. Our next question comes from the line of Steven Fisher with UBS. Thanks. Good morning. Good afternoon, Steven. Good afternoon, good morning. Wondering about your visibility into 2016 at this point. How much of the 60% growth in orders in Europe would extend into 2016, and to what extent do you have North American orders for 2016 yet? I'd say most of the orders for DAF are 2015 build. Some 2016 orders, but not a significant amount. I would say that the build in North America, just a few long-term fleet orders that are in the backlog, but not a substantial percentage of 2016 expectations. Would that be about typical with where you'd expect to be for this point in the year? Yeah, we're right where we expect to be. A lot of discussions are going on right now with customers about their plans for 2016. Indications are that purchase expectations will be very similar to what we've experienced in 2015. Okay, great. Then very solid $600 million of free cash flow in the first half of the year. How do you see that shaping up in the second half? It looks like your CapEx is scheduled to pick up by maybe a couple hundred million, but how about on the operating cash flow side? I think the operating cash flow will be very consistent from what we've seen in the first half. As you mentioned, the pace of investment in some of the capital projects will likely accelerate, and we'll continue to invest in R&D. Great. Thanks very much. Thank you. The next question comes from the line of Nicole DeBlase with Morgan Stanley. Yeah, thanks. Good morning, guys. Good afternoon. Hello. Ron, I guess my question is around the 3Q guidance that you gave. Can you give a little bit more on order of magnitude? I know it's normal seasonality to see production kind of dip down in the third quarter as well as gross margins. But can you characterize that at all versus what we saw in 2Q? Yeah, I think it is, as I mentioned, just the fact that we typically have a summer shutdown period in Europe, and that is two full weeks and two partial weeks, which impacts the level of production. That is just normal business. From a margin perspective, as I mentioned, you do have some operating leverage effects of that, and the mix of customers is a little bit more tilted towards the fleet side during the third quarter than what we saw in the second quarter. Okay, any change to the full year? I think you guys previously were saying about gross margins about in line with what you reported during 1Q, which would have embedded like 100 basis points of gross margin expansion. Yeah, I think given the performance in the second quarter, it would probably be up a bit from that. Okay, got it. Thanks. I will pass it on. Thank you. The next question is from Seth Weber with RBC Capital Markets. Hey, good morning. Yeah. Good afternoon. Just going back to the customer mix, with the fleets, do you expect that to revert back in the fourth quarter to more like what we saw in the second quarter? I am just trying to understand if this is kind of just a seasonal hiccup that you usually see or if there is something structural that is changing here. No, it is just normal month-to-month, quarter-to-quarter change in who we are building trucks for. Okay. Nothing more than that. The order book reflects that it would shift back the other way? Yeah, again, it is just pretty normal. Okay. If I could just clarify something. The $4 million currency benefit that you talked to in the prepared remarks, was that on the FinCo or is that a total company contribution to profit? That was on the financial services. It was a reduction of financial services profit for the second quarter versus the second quarter last year. Is there a number for how much currency affected the manufacturing business in the quarter for profitability? Yes. I'll just get our hands on that. You're looking for the quarter. Right. Yeah. The quarter for the truck and other, it was a $12 million of pre-tax profit negative impact. That was largely offset by favorable cost on the engine content side from our engines being built in Columbus, Mississippi. On the parts side is about a $12 million pre-tax profit impact. In aggregate, about $24 million total? Yeah, then the $4 million from financial services, in the aggregate about $28 million. Wow, okay. That's super. If I could just sneak one last one in. The SG&A continues to be lower than what we've been expecting. Is this a sustainable level, do you feel like? Well, SG&A has been benefiting from the impact of currency. A lot of our SG&A is outside the U.S., and so we've had some currency benefit. But the level that you're seeing is sustainable at these currency levels. Terrific. Thank you very much. Thank you. The next question comes from the line of Andy Casey with Wells Fargo. Hey, guys. How you doing? Good afternoon, Andy. Good afternoon to you, Ron. Could you help us a little bit more with the Q3 comment around production? Are you basically expecting U.S./Canada build to be reasonably constant and then everywhere else basically to be down? I mean, it's all reasonably constant. I think we're talking about a 1%-2% reduction in total truck production for the quarter. So it's going to be pretty comparable. Okay. And then the EBIT margin improvement in parts, it has been strong year-over-year for a couple of quarters now. Are we beginning to see the improvement related to the increased proprietary engine content that you introduced a few years ago start to run through the parts line, or is it just fundamentally the mix that you talked about? No, I think there is definitely some benefit from higher increased engine parts sales. We are up to about 90,000 MX engines in the field in North America and hundreds of thousands of engines in the field in Europe. That population continues to grow, so we see the benefit of that. Paccar Parts has done a nice job of developing Paccar brands and transitioning more and more of the parts sales to Paccar-branded components. I think execution by our parts team has been excellent. Andy, this is Bob. I would add that there continues to be excellent leverage in the parts business from our distribution centers globally. We are benefiting from lower freight rates due to fuel prices. Okay. Thanks a lot, Bob. Thanks, Ron. Thank you. The next question comes from the line of David Leiker with Robert W. Baird. Hi. Good morning, everyone. Morning, David. Where are you tracking right now in North America and Europe in your truck plants for capacity utilization? We have lots of capacity available in most of our factories to be able to produce trucks to meet customer demand. That's not a concern for us. Okay. There's a lot of discussion about where we are in the cycle and, let's say we're in an elongated cycle here where economic growth continues to muddle along like we are, and demand for trucks stays where it is. In that environment, what kind of ability do you think you have to push margins higher, given a relatively constant level of high demand? Well, operating leverage is a very positive thing, so to the extent that we can further take advantage of that is some upside, but it is a competitive market and we have great products to provide to our customers and we expect to get good value for what we are producing and we expect that to continue over time. We continue to look for ways to make our plants continuously more efficient and achieve cost reductions to improve our results. Okay. Thank you. Thank you. The next question comes from the line of David Raso with Evercore. Hi, thank you. The stock's not really responding that much to a pretty strong print here, so folks are obviously concerned about your ability to grow earnings next year. Can you help us understand a little bit then the moving parts of the incremental margins? Let's strip out currency. If somebody's looking at Europe next year, let's assume they think it's up. Can you help us understand the incremental margin difference that we can expect, say, even what you're seeing right now or just some framework of how to think about if you want to model Europe up, what kind of incrementals can you expect in that region to maybe offset some of the North American decrementals? Well, I mean, David, we obviously expect to the extent that we can increase production levels, there are some operating leverage benefits that go with that. If you look at the performance over time, incremental margins have been 20% plus or minus, and so that's probably more indicative of the longer-term trend. To the extent that we can get additional volume, I would expect we'd see that kind of performance going forward. But the question was splitting the geographies, because at least the base case is they're going opposite directions, right? If North America is down 10% and Europe's up, you name the number, 15%, 20%, whatever it may be, people are trying to figure out, of course, North America is larger. But what kind of incremental margins could one expect from Europe, given you're more vertically integrated there, but obviously pricing is still a bit challenged there. So if you can help us at all differentiating between North America and Europe on incremental margins into next year. I think the incremental decremental is very comparable across the geography, so there's no significant difference. Okay, that's helpful. I appreciate it. Thank you. You betcha. The next question comes from the line of Ted Grace with Susquehanna. Hey, guys. Good afternoon, Ted. First thing, I was just wondering, could you just walk through deliveries by region? Sure. We actually added a table in our press release at the very end of the schedules. Oops, I apologize, I missed that. That's okay. Okay. That's helpful. It's the- Second thing I was hoping you might be able to walk through is, just in terms of, I guess the situation in Europe with the EC. I know you provided an update in the press release saying that you're unable to give an estimate for the impact. I was just wondering if you could remind us why you can't quantify that. I recognize that there can be different reporting requirements for U.S. versus European companies. But just as a reminder, can you just give us the reason why we can't walk through a quantitative framework? On a related basis, would it be fair to assume we could look at the European competitors at least as a framework to think about Paccar's exposure? I can't comment on what the competitors have done and our press release has an update and not any significant developments during the quarter. That's about all I can say about that. Okay. Maybe the last thing if I could just ask, I know you said there are a lot of great things going on in the business. I think the numbers speak for themselves. But can you talk about where your biggest concerns are? What's keeping you up at night? Anything that's on the horizon that you're very mindful of that you would point to? We have a great team that delivers great results as evidenced by the press release, and so I sleep pretty well most nights, I got to tell you. There's always challenges, always opportunities, and so we look forward to seizing those and taking advantage of those as we move forward. That'll always continue to be our approach. Okay. Well, thank you very much, and best of luck this quarter, guys. Thank you. The next question is from Ross Gilardi with Bank of America. Yeah, good morning. Thank you. Good afternoon, Ross. I just wanted to understand on the deliveries versus the geographic revenue breakdown. You had an 8% decline in European sales on a 25% increase in deliveries. I understand what's happened with the euro dollar, but even if you factor that in, this seems like there's a big gap, and I'm wondering if you can help bridge that. Is that pricing or something with the mix or any help there? The effects of the EUR on revenue for the quarter was about $250 million. You add that back to the equation, and part of it is a little bit larger mix of the light-duty trucks, the Model LF, compared to the CF/XF mix during the first half of last year. Anything in particular driving that? No, just customer demand. All the trucks are great, and the LF is particularly popular in the U.K. and very well received by customers, and that market has grown a little faster than the rest of Europe, reflecting their economic growth, and we're seeing some benefits from that phenomenon. Got you. Then just back on the parts margin. You have had two consecutive quarters of 18%-19%. Should we look at this as sort of the newer and higher baseline going forward? Is there any reason why that number actually cannot go up if you continue to post 6%-8% organic growth in the parts business over the next several years like you kind of have in the past? I think as Bob said, we have gotten the benefits of operating leverage, and that should continue. Obviously, freight rates are dependent a lot on diesel prices, and so that will go up or down as diesel prices move. But again, our teams have done a good job of transitioning to Paccar-branded components, and with our newest designs, we have a higher element of proprietary content. So I think we are in good shape and positioned well, and you should not see significant movements from where we are at currently. Got you. Thanks very much. Thank you. Our next question comes from Mike Shlisky with Volvo Hunter Research. Morning, guys. Good afternoon. Wanted to ask you guys about Brazil. It wasn't really mentioned in the press release or any of your comments. I know it's been a really rough market this year. Kind of wondering if you can give us your thoughts as to how that's going and whether the DAF volumes there are ramping in line with your expectations. We continue to be a pretty small player in that market. Our team is doing great. The factory is running very well. The quality of the product is excellent and very well received by the customers. Our dealers continue to invest in their facilities to fully represent the DAF brand in the market. The market this year will be down substantially, probably in the 45,000-55,000 truck range. South America total, probably 70,000-80,000 trucks for the year. But we have a great team and a great long-term perspective on building our business. And it will be a bigger and bigger contributor to Paccar's results over time. Okay, great. My other question is about the new parts DC that's opening in 2016 in Washington. I guess, is there any chance for any kind of a gross margin impact while there's some kind of a transition or in the opening process there? No, that's a- At some point during 2016? No, we open and expand distribution centers on an ongoing basis, and it's just part of continuing to support that growing parts business and our dealers' needs to have same-day delivery to meet their needs. No, there won't be any margin impact as a result of that transition. Okay, great. I'll leave it there. Thanks so much. Thank you. Our next question is from Scott Group with Wolfe Research. Hey, guys. Just one quick question. The 40% that you're doing with your own engines in the U.S., any update on the near and long-term target there? I think we'll continue to see that grow. More and more customers, a lot of times they'll start with some level if they're a larger fleet, and as they get experience, most will often increase their percentage penetration in their fleet with the MX engine. So we expect that to continue to grow 50%, 60% over time. The engine has the capability to meet about 80% of our customers' needs. So we're very excited about the potential for that as we progress over the next three to five years. Today in the North American market, we offer the PACCAR MX-13. Beginning next year, we will also be offering the PACCAR MX-11 engine, which was introduced in Europe a couple of years ago and to great success. We will be enhancing the North American engine lineup. Is 50%-60%, you think that is a realistic target for next year? Yeah, I think over time. Okay. How about on the medium-duty side? We install Paccar engines, branded engines purchased from Cummins for our medium-duty product. I guess the question was, do you think about expanding into medium duty on the engine side here in North America? It's always a possibility, but nothing on the short-term horizon for us in that area. All right. Thank you, guys. Thank you. As a reminder, if you would like to ask a question at this time, simply press star, then the number one. Again, to ask a question, please press star one. The next question is from Ted Grace with Susquehanna. Hey, guys. I just wanted to follow up on kind of the outlook for the MX platform, the 13 specifically. Have you entered into conversations with other OEMs, unnamed, who might be interested in buying that engine from you over time? Is there an opportunity that you could sell that to competitors? Typically hasn't been our approach. We have a great engine to support our product, and we got the capacity to support future growth, but selling to other OEMs is not an avenue that we've thought about pursuing. Could it be conceivable if it obviously gets you volume and not just pull through, but obviously profit margin with that? Yeah, it is possible, but really not part of our thought process at this time. We do sell a handful of engines to luxury bus and coach manufacturers, but it is really not significant in terms of overall production mix. Got it. Okay, great. That was just a quick follow-up. Thank you. Thank you. There are no other questions in the queue at this time. Are there any additional remarks from the company? I would like to thank everyone for their excellent questions, and thank you, operator. Ladies and gentlemen, this concludes Paccar's earnings call. Thank you for participating. You may now disconnect.