Earnings Call: Q1 2014

Apr 29, 2014

Summary

Q1 net income rose 16% YoY to $274M on $4.4B in sales and financial services revenue. Truck deliveries rose 4%; Q2 deliveries were expected to increase 8%-10% sequentially, while Euro VI transition pressures tempered margins.

Good morning, and welcome to Paccar's first quarter 2014 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 an objection, they should disconnect at this time. I would now like to introduce Mr. Robin Easton, Paccar's Treasurer. Mr. Easton, please go ahead. Good morning. We would like to welcome those listening by phone and those on the webcast. My name is Robin Easton, Treasurer of Paccar, and 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 participating, we request 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 improved revenues and net income for the first quarter of 2014. Paccar's first quarter sales and financial services revenues were $4.4 billion and quarterly net income was $274 million, an after-tax return on revenues of 6.3%. Net income increased 16% compared to the results generated in the first quarter last year. I am very proud of our 21,700 employees who have delivered industry-leading products and services to our customers worldwide. 2014 marks another major milestone for Paccar, with Peterbilt celebrating its 75th anniversary. The company's 75-year tradition of excellence and innovation has established an uncompromising focus to deliver the highest levels of product quality, customer satisfaction, and return on investment. Paccar delivered 31,800 trucks during the first quarter, a 4% increase versus the first quarter last year and in line with our expectations. The improvement reflects increased truck deliveries in the U.S. and Canada due to the ongoing replacement of the aging truck population and improving construction and automotive sectors. Looking ahead, we expect to increase truck deliveries in the second quarter by 8%-10% compared to the first quarter. Second quarter gross margin should be somewhat higher than the first quarter, reflecting the benefits of higher production levels and improved operating efficiency. It is encouraging that housing starts in the U.S. are over 900,000 units and there is growth in non-residential construction. Other good economic news is that U.S. auto production should be around 16 million vehicles this year. These positive trends should benefit truck demand in North America. U.S. and Canadian Class 8 industry truck retail sales are estimated to be in a range of 220,000-240,000 units this year, up from 212,000 units in 2013. The stronger market reflects ongoing replacement demand and some expansion in industry fleet capacity due to continued strong freight fundamentals. Industry truck orders for the U.S. and Canada in the first quarter were 80,000 units. Economic news in Europe is trending positively with GDP growth expectations for this year of 1%. Freight in Germany, as measured by the Maut Index, has risen 5% compared to the same period last year. Europe's greater than 16 ton market is projected to be in a range of 200,000-230,000 units. Customers in Europe accelerated purchases of Euro V vehicles in the second half of last year and are adjusting to the increased prices of Euro VI trucks. Production of DAF trucks in Brazil is progressing, with production levels expected to increase gradually through 2014. Paccar Parts business generated quarterly revenues of $727 million, a 9% increase compared to $667 million in the same quarter of the prior year. Paccar Parts quarterly pre-tax income was $112 million, an increase of 18% compared to the $95 million earned in the first quarter of 2013. The strong results were driven by increased freight tonnage, improved fleet utilization, and the many innovative products and services offered by Paccar Parts. Paccar Financial Services revenues were $294 million in the first quarter, comparable to a year ago. Paccar Financial's first quarter pre-tax income was $86 million compared to $80 million earned a year ago. The improved results benefited from growth in asset balances and excellent portfolio performance. Paccar's strong balance sheet and positive cash flow have enabled the company to invest over $2.2 billion in new products and facilities in the last three years. Paccar began production of the new vocational Kenworth T880 and the Peterbilt Model 567 trucks in late 2013. These new vehicles expand Paccar's offering in the construction, utility, and refuse markets and complement the Kenworth T680 and Peterbilt Model 579 on-highway trucks launched in 2012. The launch of the new DAF XF, CF, and LF Euro 6 vehicles in 2013 strengthens DAF's position as the leading provider of integrated transport solutions. Paccar's capital spending of $300 million-$350 million this year is targeted at enhanced powertrain development and increased operating efficiency of our assembly facilities. Research and development expenses are estimated to be in a range of $200 million-$250 million. Paccar continues to enhance its leadership position in the global truck market by developing the highest quality products and services in the industry and by investing in new geographic regions. Thank you. I would be pleased to answer your questions. Thank you. At this time, I would like to inform everyone in order to ask a question, please press star then the number 1 on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Our first question comes from the line of Jamie Cook from Credit Suisse. Good morning, Jamie. Actually, this is Andrew Kaplowitz on behalf of Jamie Cook. Well, good morning, Andrew. Good morning. I just have a quick question. Can you just comment quickly on your Paccar Parts business in the quarter, and what you are seeing particularly across each region? Yeah. The Paccar Parts business had good growth, I'd say slightly a little bit stronger in the U.S. and Canadian markets compared to some of our other markets, but good growth in really all regions for the quarter. I think that's evidence of the improving freight conditions that we've seen both in North America and Europe. Okay. Then, just along those lines, given how the U.S. has trended, going forward, what do you guys see for the remainder of the year, in terms of just the North American market? Are you talking about the truck market or the parts market? Yeah, trucks. Yeah. Our projection for U.S. and Canada is in the range of 220,000 to 240,000 units. We are thinking that the market will progressively improve as we go through the year, and we talked about our planned production increase of 8%-10% in the second quarter. All right. Thanks, guys. Sure. Your next question comes from the line of Steven Volkmann from Jefferies. Morning, Steven. Good morning, gentlemen. Thank you for taking the question. I am going to drill in a little, if you will let me, on this production increase of 8%-10% in the second quarter. Sure. Can you just give us a rough magnitude of how that breaks down, sort of U.S. versus Europe, and then maybe even heavy versus medium, if you would? I would say, on the heavy versus medium, I would say that the increases are comparable across those categories. In terms of geography, I would say the increase in the U.S. and Canada is probably a little bit higher than that average percentage, and Europe is a little bit below that. Okay, great. That is helpful. Can you talk a little bit, I think historically, once we hit some sort of inflection point, I am not sure really where that is, but we would expect to get a little bit better pricing, as you start to build the backlog further out. Are we there yet? Is that happening or is this maybe something different this cycle? Just any comment on that. Well, I think, as we've progressed through the market, we continue to work closely with our customers and be very competitive in the marketplace, providing the best solutions. You look at things like our industry-leading residual values, allows us to provide a very competitive price to our customers with the lowest operating life cycle costs of any of the manufacturers. We can provide a very attractive proposition, and we'll continue to gauge the market and price accordingly. All right. Maybe more simply then, is pricing up year-over-year or flat or down? I would say it's maybe up a bit. Okay. Thank you so much. Yeah, sure. Your next question comes from the line of Ross Gilardi from Bank of America. Good morning. Thanks very much. Morning, Ross. I was just wondering if you could talk a little bit more about Europe. Some of your other competitors have kind of suggested things are maybe slightly better. Can you talk a little bit more about DAF orders during the quarter? Sure. As we transition from Euro V to Euro VI, I'd say orders started off in the first quarter soft in January. We've seen progressive improvement through February and through March, and we've got some good momentum as we head into the rest of the year. So we feel good about DAF's continued strong position in the European market. Then, just shifting to Brazil, obviously the economy faces challenges there. Is it making it tougher for you to gain traction there? Many of your peers seem to be complaining about the slowing environment and pricing pressure. Obviously, you're kind of starting more from a ground zero position, but what's your thoughts on Brazil? Yeah, I think Brazilian market does have its challenges, but as you mentioned, we're in a startup mode, really focused on getting our production, our distribution network well established, doing it all right first time, if you will. So market conditions aren't as significant to us, and we'll continue to progress in our build plans. Shouldn't affect our plans for 2014. Okay, great. Then just lastly, I'm just wondering, can you give a little more color on why you think orders have been so strong in North America so far year to date? What are you hearing about from customers on sustainability? Is the issue that your customers are finally getting pricing power for the first time in a long time and therefore, are now willing to invest? Anything you can provide there will be helpful. I think it's a matter of confidence. You look at the customers today, and over the past years, there's been a lot of uncertainty about how significant the economic improvements might be and what might the government do. I think, with some of the positive things that the government was able to achieve in the fourth quarter last year with solid budget plans without stopping the government. I think people feel better about the ability to support keeping their trucks active and being able to get fair rates for their business. So I think it's a matter of confidence. Thanks very much. Sure. Your next question comes from the line of Andrew Kaplowitz from Barclays. Hey, Ron. Hey, Andrew. Hey, how you doing? Nice quarter. Thank you. Can I ask you about your other revenues? You've talked and broken up in the past by geography. Maybe if you could do that again. The numbers sequentially continue to come down a little bit. Has there been an impact on your Russia business, and is Mexico still kind of weak when it comes down to it? Yeah, I think there is some softness in Mexico. We saw that their economic situation was challenging in the second half of last year, but I think we're starting to see some signs of recovery in that market. Australia's been up and down a little bit with the effects of the mining industry, but starting to see some solid business there. I think we see some of the other markets starting to show some positive signs. Okay, then maybe could you talk about the penetration of the new products that you've had over the last six months, a lot of vocational trucks. I would assume that they come with modestly higher margins. Maybe you could talk about the overall construction market and its receptivity to these trucks. Have you seen a pretty good growth rate out of these trucks here in the early going? Yeah, this is Bob Christensen. The impact of production with our new models at Kenworth and Peterbilt is about 50% new model production. Of course, DAF is almost 100% with their new Euro 6. With respect to the vocational market, we're seeing strong growth in the overall market, and both Kenworth and Peterbilt have high penetration levels. We're selling a lot more vocational trucks than we have over the last three or four years, and that's good for Paccar and good for our customers. Thanks, guys, appreciate it. Sure. Your next question comes from the line of Jerry Revich from Goldman Sachs. Morning, Jerry. Hi, good morning, and Ron, formally, congratulations. Thank you very much. I'm wondering if you could talk about the margin ramp over the course of the year. Presumably, as Europe ramps up, margins should improve each quarter sequentially from here. But can you just help us with the order of magnitude of improvement in the second quarter? Can you come close to the 13% gross margins you were delivering last year, or do you need a healthier European truck production environment before we could talk about that margin range? I think we see second quarter margins probably improving somewhere in the 20-40 basis point range for second quarter. Continue to be able to leverage our cost structure. DAF, in the first quarter, transitioned its production from roughly 15% Euro 6 vehicles to 80% Euro 6 vehicles. That transition now is done, and the DAF team did a tremendous job of really transitioning that product line and achieving great production efficiency as they transition. We'll continue to see, depends on the market conditions, et cetera, but we're well-positioned to the extent that we're able to continue to increase our production levels, we'll achieve some level of operating efficiency with that. Okay. In Brazil, I know your All-Makes parts business is a big part of the distributor build-out strategy. Is that a significant enough part of the parts franchise where you can give us a sense for how that's going? Could you just give us, if you could, an update on the broader distributor build-out there? The parts business will start slow in Brazil, and will build out over a long period of time. Certainly, the All-Makes program that you referred to is an important part of our strategy. We have 20 dealer locations in Brazil, and they're all beginning to sell both trucks and parts. But it's going to be a slow ramp-up over the next several quarters, if not years. From a capital deployment standpoint, Ron, I think you've in the past spoken about a 45% to 50% net income payout ratio. Is that still the way to think about business, and any other capital uses that we should be thinking about? Obviously, first point of investment is back into our products and our services and our facilities to make sure that we can continue to provide the best trucks and the industry-leading operating efficiencies that we're accustomed to. Our payout ratio has been in the range that you talked about, but obviously, that's a matter that's reviewed and discussed with the board over time. We'll continue to monitor that and adjust our capital deployment strategy as we go forward. Okay. Lastly, I think you did nudge down your CapEx and R&D outlook for the year. Can you just give us a sense for what's driving you, I guess, to the lower end of the previous range? Yeah, as we look at the specific things that we're doing, we continue to invest strongly in our products and our services. As we look at where we're at and where we're going, just felt like we're probably going to be at the lower end of those prior ranges as we look forward. But there's a lot of things that we're looking at as we go forward to maintain a strong, steady flow of new products and services and keep improving our warehouse and plant operating efficiency. Thank you very much. Thank you. Your next question comes from the line of Rob Wertheimer from Vertical Research. Hi, Rob. Good morning, everybody. Thanks. Just a quick question on the gross margin in the quarter, which is lower than it's been for a long time, and the overall margins weren't all that bad, obviously, but curious as to whether that was the pass-through of the European price increase, whether that was mix in the U.S. Maybe if you just give some color around it. Maybe you didn't see it as all that bad. I just wanted your take. I think we feel good about how the teams performed around the world. In Europe, their Euro VI product, as I mentioned, was a higher percentage of our deliveries in the first quarter, and with that comes about a 15% average price increase for the price of a Euro VI truck. We were able to recover that cost increase, but the ability to make a margin on that increase was challenging, just given the transition in the competitive environment that we were placed with in Europe. Okay, great. If you could just comment on, if you're willing, on the margin environment in the U.S. Perhaps it was more big fleet deliveries then, and it will be for the rest of the year. I don't know if it was an abnormally fleet-driven quarter. No, margins are solid. Our teams are doing well, and we are competing very well in the marketplace. So we feel good about where we are at in North America with margin-wise. Great. Thank you. Thank you. Your next question comes from the line of Seth Weber from RBC Capital Markets. Hey, good morning, everybody. Just following up on an earlier question on Europe. The trends there do seem to be a little bit better than expected. Is there something that you're seeing that's preventing you from raising your market outlook for the European market this year? Or you're just trying to be conservative? Yeah, we didn't feel like there was enough evidence at this point to raise our outlook because there's a mix of Euro V and Euro VI trucks that are being registered and delivered to customers right now. We felt like we'll continue to monitor that, and as we always do, we'll be smarter in 90 days than we are today. We'll modify our market estimates as we see fit, based on how things develop. But didn't feel like there was enough evidence probably to change at this point. Okay, understood. I guess, a follow-up question on the MX-13. Can you give us the penetration there on the Kenworth and Peterbilts and just an update on where you are with capacity? Yeah. The MX is 35%-40% of our builds for Kenworth and Peterbilt heavy-duty trucks. We continue to support the production and have great shape from a capacity standpoint, and lots of opportunity to continue to grow that penetration within our product line. Okay. That is all I had. Thank you. Thank you. Your next question comes from the line of Ted Grace from Susquehanna. Morning, Ted. Hey, guys. Nice quarter. Thank you. The first question I have is a follow-up on Jerry's. He'd asked about the operating margins relative to a year ago. Ron, you mentioned you thought you could extend them 20 to 40 basis points. Was that a sequential comment or a year-on-year comment? That's a sequential comment. Yeah. Okay. That's helpful. Then, as it relates to Europe, could you just bifurcate how you're thinking about kind of the U.K. versus the continent in terms of end market improvements in 2014? Yeah. So the U.K. and the Netherlands, they followed one set of Euro V, Euro VI transition rules. The other markets followed a different set. You saw in the first quarter registrations, the U.K. and the Netherlands were down, and those are markets where DAF has a market leadership presence. On the continent, Germany, France, Spain, had increases, again, because they had different transition rules for Euro VI. So I think we'll see that the U.K. and the Netherlands will accelerate in terms of total market because the U.K. economy's good, and the Dutch economy is starting to show signs of improvement as well. Okay, that's helpful. Then the last thing before we get back in queue. Over the last couple of years, the first quarter has tended to be the most weighted on SG&A. Is that a progression we should look for to repeat itself in 2014, or might there be any change in that normal pattern? No, I think that's probably what you should think about it. The SG&A numbers will be comparable to a little bit down, maybe as you progress through the rest of the year. Okay. Well, that's great. Best of luck this quarter, guys. Thank you. Your next question comes from the line of David Raso from ISI Group. Morning, David. Hi, good morning. First, a clarification. When you said margins up 20-45, 1Q to 2Q, that was gross margins, not operating, correct? That's gross margins, yes. All right. Okay. Those are two different answers. Gross margins. Yes. On the production, the first to second quarter, just hopping between a lot of calls today, my apologies. Can you state again the production changes first quarter to second quarter, then an answer to an earlier question, North America versus Europe? Can you just repeat that, please? Our expectation is for overall production to be up 8%-10% in the second quarter compared to first, with slightly above that average in the U.S. and Canada, and slightly below that average in Europe. I do not have the detail yet about the truck sales with the breakdown. I am going off of more kind of total geographic revenue, so I apologize. Does that seem to imply that we are going to be up in Europe again year-over-year in revenues in the 2Q? Again, remember that the Euro VI vehicles, the average sales price for a Euro VI truck is about 15% higher than a Euro V vehicle. That is part of the equation. Well, maybe that is my question. Sorry to interrupt. When you say production, I am thinking unit production. You are speaking in revenues. Yeah. Production and deliveries are the same for us. Okay. That is the distinction. Sure. So it is the pricing which is particularly helping the sequential Europe. Are units going up sequentially, 1Q to 2Q? They are, yes. When I talk about the 8%-10%, that is units. Okay, so that was different than what you just said. 8%-10%, North America up more, Europe up a little less. That is units or is it including the pricing from Euro VI? I apologize, just to be clear. That is units. That is interesting. If units are up that much, and then the pricing on top of it, because I assume there is even a little heavier mix Euro VI in the first quarter, so you had some Euro V going out to start the quarter. Yep. The year-over-year growth in Europe sounds healthy in 2Q. North America, strong. I do appreciate you're not getting any margin on that Euro VI price increase. But with that backdrop, the gross margins still seem to be a little more challenging you would've thought. Just trying to flesh out why the gross margin's going to be, let's just take the exact comment, 20-40 bps at only 12.3%. Why would that not be up more? I'm just trying to be clear. Is there something about North America or is it, "Look, we're just not getting any incremental margin on that Euro VI pricing. Yeah, there's not any incremental margin on the Euro VI pricing as we sit here today. Now, as we progress through the year, the market improves, could be an opportunity. The last question related to that, do we expect the gross margin to be up year-over-year at all in this year, meaning third quarter or fourth quarter? Because obviously the second quarter's implied it's down year-over-year again. I think as we look forward, as we see today, the margins this year would be comparable to the prior year, but that'll depend on how the markets progress, how the pricing situation progresses, et cetera. So there's a lot of variables in that equation. Okay, to get back to full year the same, we do need a little bit of growth somewhere year-over-year Yes in the second half. Okay, that's helpful. I really appreciate the detail. Yeah. Thank you. Absolutely. Your next question comes from the line of Neal Fernagle from Longbow Research. Hi, good morning again. Hi, Neal. A follow-up to Seth's question on the MX engine. Parts segment pre-tax margins were at a record level in the quarter. Just wondering if you're starting to see benefits from the increased MX penetration rate that's occurred over the last few years, or is that a tail and that could still be to come? Oh, I think it's still to come. Obviously, the more engines we have in the part, the more opportunity we have for parts sales, but that's still developing. That part, because we're up to 55,000 engines that we've put into Peterbilt and Kenworth vehicles. It's a great story, but one that there's still a lot more upside as we progress. Got it. Sorry if I missed this, but can you provide a breakdown of the new truck deliveries by geographic region in the quarter? I think you mentioned 31,800 for total company, but just wondering if you can provide more granularity between Europe and North America. Sure. For U.S. and Canada, 18,600 units, Europe 9,300, and rest of world 3,900. Great. Thanks very much, guys. Thank you. Your next question comes from the line of Jeff Kauffman from Buckingham. Thank you very much. Actually, a lot of my questions have been answered, so I'll just follow up on an earlier clarification. The gross margins, you mentioned you're just not getting gross margin on the increase in Europe, but that doesn't explain the full amount. And it looks like gross margins are trailing down 50, 60, 70 basis points. Is there anything else in there that's kind of complicating that analysis? No, I don't think so. Obviously, we're in a startup mode in Brazil, but we feel good about where we're at, and the margins are solid. Okay, great. We'll see you at the Analyst Day. Thank you. Thank you. Your next question comes from the line of Alex Potter from Piper Jaffray. Morning, Alex. Morning. First of all, I guess I had kind of a high-level philosophical question here, and I guess you could kind of break it into two parts. Number one, do you think over the next 2, 3, 5 years, there's going to be a higher percentage of fleet buyers as a result of hours of service and everything else pushing these smaller fleets and owner-operators out of the market? That's part one. And part two of the question is, if so, do you think that that's going to drive I guess, lower peaks and higher valleys or less kind of amplitude in the truck cycle as we go forward? I guess we've seen that trend with fewer owner-operators, more fleet buyers in the market over the last five, six, seven years. Will it continue, or is it to a point where it's about where it's going to be? I don't know, but we're ready to be able to flex to however the market evolves. I think we've seen customers being very prudent in their purchasing habits over the last two or three years as there's been uncertainty. Will that lead to less volatility? I don't know. But clearly, I think buyers of trucks have exercised restraint, if you will, as they've lacked the clarity of their ability to put trucks into operation and maintain those. I think we're seeing improved confidence in that realm. So, as backlogs get extended, whether that changes, we'll see how it develops. Okay, thanks. I guess the last question here is just on natural gas. I was wondering if you could give a quick update. Also, if possible, what percentage of your production approximately right now is natural gas? Thanks. Well, we continue to be the leader in the natural gas business, but it continues to be very much a niche market. It's probably 1%-2% of our production. It's what we see, and it's what the industry is seeing. So as we look forward for the near future, it will continue to be a niche market, one that we're prepared to serve, but not a major element. Okay. Thanks very much, guys. Thank you. Your next question comes from the line of Scott Group from Wolfe Research. Morning, Scott. Hey, thanks. Morning, guys. I know there's been a lot of questions on the gross margin. I want to ask one on the operating margin. If I kind of plug in what you guys are kind of implying for revenue and gross margin, it's tough for me to see much operating margin or any operating margin improvement in the second quarter. I know you saw good operating margin improvement in the first quarter. Just wondering, does that sound about right with the way you guys are thinking about it? Well, I don't have those numbers lined up in front of me. I think as we look at our R&D spending range, our SG&A, we feel second quarter we'll see numbers comparable to first quarter in those areas. I think the operating margin probably would be, in terms of trend, similar to what the gross margin has trended from first to second quarter. Okay. That makes sense. Yeah. In terms of share, down maybe just a little bit year-over-year, or I know it can be choppy, but how are you thinking about Class 8 share going forward the rest of the year? Well, obviously, Peterbilt and Kenworth have some great new products that they've launched in the last 6 to 18 months, and those markets have gained great acceptance with our customers. As we continue to add additional features and elements that the market expects, then we'll continue to grow that. Peterbilt and Kenworth are in great shape. Market share has been very consistent over the last 2, 3 years, and we think there's more upside as they continue to get more customers in these new trucks. Okay. Just last one, if you go back historically after a new big product launch or new technology or regulation where the cost of the truck goes up a lot, how quickly after that, is it a quarter, two quarters, a year before you can start to make a little bit of a margin on that price increase? It's really dependent on the market conditions. If there's an improvement in market demand, that opportunity can present itself. But if you recall in 2010, it's a big increase, and it takes a while to work through that. Okay. Thanks, guys. Appreciate it. Thank you. Your next question comes from the line of Sarah Majors from Wells Fargo Securities. Good morning. I am on for Andy Casey. Morning. Good morning. Most of our questions have been asked and answered, but I wanted to explore the pricing question a little bit more. I know you had said that pricing was up a bit, but could you give us a little bit more color on how pricing trends are geographically, either U.S. and Canada and then the European market? Then how competitive are those in the market versus the recent past? I think we talked about Europe, that the pricing is up, consistent with the additional content that is added with Euro VI. In North America, again, we are looking at small price realization enhancements as the market allows. It is always competitive. That is the nature of our business, and you always look to have the best value. You are looking at the opportunity to provide your customers the best transportation solution, and that includes operating costs and residual values. We think we have a great solution for our customers. In the U.S. and Canada, what is the competitive environment surrounding pricing? It is always competitive in all markets. It is what we do. We have great new products and great dealers and excited employees, and we are pushing ahead and making inroads with new fleets that are appreciating the new Kenworth and Peterbilt models. But for as long as I have been here, it is always competitive. Thank you. Thank you. There are no questions in the queue at this time. Are there any additional remarks from the company? I'd 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.