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Cummins [CMI] Conference call transcript for 2015 q4

2016-02-04 17:00:00

Fiscal: 2015 q4

Operator: Good day, ladies and gentlemen, and welcome to the Q4 2015 Cummins, Inc. Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. . As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Mr. Mark Smith, Vice President of Investor Relations. Sir, you may begin.

Mark Smith: Thank you. Good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the fourth quarter of 2015. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; President and Chief Operating Officer, Rich Freeland. And we'll all be available for your questions at the end of the teleconference. Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed Annual Report on Form 10-K, subsequently filed quarterly reports on Form 10-Q. During the course of this call, we will be discussing certain non-GAAP financial measures, and we'll refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release, with a copy of the financial statements and a copy of today's webcast, available on our website at under the heading of Investors and Media. Now, I'll turn it over to our Chairman and Chief Executive Officer, Tom Linebarger.

N. Thomas Linebarger: Thank you, Mark. Good morning. I'll start with a summary of our fourth quarter and full-year results and finish with a discussion of our outlook for 2016. Pat will then take you through more details of both our fourth quarter financial performance and our forecast for this year. Included in our fourth quarter results were three unusual charges, which I will cover before summarizing our operating results. As market conditions weakened in the fourth quarter, we made a decision to scale back the range of light-duty engines that we plan to manufacture in North America. This decision combined with the uncertainty of winning additional customers with our V8 engine in the short-term caused us to reassess the book value of our light-duty manufacturing assets in North America in the fourth quarter. As a result of our evaluation, we recorded noncash pre-tax impairment charge of $211 million. While it's disappointing to record the charge, we remain committed to our light-duty engine customers and confident in the growth prospects for our light-duty engine business globally, including the V8 engine in North America. Included in the fourth quarter Engine business results is a $60 million charge related to a quality issue impacting specific population of vehicles manufactured by one OEM customer. The quality issue is a result of a defect in the substrate washcoat within a third-party after treatment system which is paired with our engines in an OEM vehicle. Cummins did not manufacture or sell the after treatment system and does not provide warranty on the OEM vehicle. As the defect is impacting performance of the overall engine system, we are taking responsibility for the effort to resolve the issue and have recorded the cost of the campaign and other related costs in other expense. In addition, as expected, we recorded a restructuring charge of $90 million in the fourth quarter. We reduced our workforce by more than 1,900 people including 1,700 professional staff and we expect that these actions will result in a full-year cost savings of $160 million. Now, let me summarize our fourth quarter and full-year results and comment on key drivers of the results within each business. All references to EBIT and EBIT percent exclude restructuring and impairment charges. Revenues for the fourth quarter of 2015 were $4.8 billion, a decrease of 6% compared to the fourth quarter of 2014. Gross margins of 25.4% were the same as a year ago, despite the lower sales due primarily to strong execution on material cost reduction projects and lower warranty costs. Operating expenses declined year-over-year both in dollars and as a percent of sales. EBIT was $531 million or 11.1% compared to $661 million or 13% a year ago. EBIT percent declined due to a change in other income or expense. In the fourth quarter of 2015, we recorded the charge for the quality campaign that I've just described in the fourth quarter. And in the fourth quarter of 2014, we generated one-time gains on distributor acquisitions. These two items explain the majority of the variance in other income or expense. For the full year, Cummins sales were $19.1 billion down 1% year-over-year. Gross margin of 25.9% improved by 50 basis points as a result of material cost savings and lower warranty costs, which more than offset the negative impacts of currency and lower volumes. Operating expenses declined in dollars and as a percent of sales. Our full-year EBIT margin was 12.5%, down from 13.2% in 2014. EBIT percent declined due to the change in other income or expense largely for the same reasons that I just described for the fourth quarter – lower gains on distributor acquisitions and the impact of the quality campaign. The Components segment delivered strong fourth quarter and full-year performance, which is largely attributable to strong execution on a number of cost reduction initiatives and successfully capturing profitable growth in China as new emissions regulations came into force. Within the Distribution business, we successfully completed the acquisition and integration of three distributors in 2015 for a total of 10 acquisitions over the past two years. Despite challenging economic conditions, the financial benefits of these acquisitions exceeded our 2013 projection, yielding $0.63 per share of additional earnings over two years compared to our original projections of $0.50 per share. EBIT margins of existing distributor operations improved by 90 basis points in 2015, and we expect further operational improvements in 2016. Unfortunately the improvements in underlying performance in 2015 were masked by the impact of a stronger U.S. dollar, which caused the results of international operations to translate into fewer U.S. dollars. We expect the strong U.S. dollar to be a continuing challenge in 2016. The Engine business faced challenging off-highway markets throughout 2015, and had to adjust towards sharp production heavy duty truck volumes in North America in the second half of the year. Our production of engines for Class 8 trucks declined by 28% between the second and fourth quarters of 2015. We quickly responded to the demand drop by flexing down our operating costs in our Jamestown Engine Plant, which will help protect margins as we head into a weaker 2016. The Engine business also made significant progress in reducing product quality and warranty costs during 2015. Warranty cost as a percent of sales improved by 90 basis points from the first half of 2015 to the second half. And we expect cost to improve further in 2016. The main challenge facing the Power Generation business is weak global demand, especially for larger units. We do not believe that the fourth quarter results represent a run rate for future performance as we did incur some additional costs that we do not anticipate will repeat in future quarters. We expect improvement in our EBIT percent in 2016 as a result of our restructuring and other cost reduction work in Power Generation. Now, I will comment on some of our key markets in 2015, starting with North America and then I'll comment on some of our largest international markets. Our revenues in North America grew 7% in 2015 with approximately 3% of the growth coming from acquisitions in our Distribution business. Industry production of North American heavy duty trucks reached approximately 290,000 units in 2015, an increase of 9% from 2014 levels. Our full-year market share was 33%, down from 35% in 2014. The market size for medium duty trucks was approximately 124,000 units in 2015, in line with 2014, and our market share improved by 610 basis points to 78%. Shipments to Chrysler increased by 5% in 2015 to 130,000 units reflecting strong demand in the U.S. for pickup trucks. Engine shipments to industrial or off-highway markets in North America declined by 29% year-over-year, reflecting weaker demand in all end markets except rail, where we picked up market share following a transition to Tier 4 Final emission standards. Revenues in our Power Generation business decreased by 9% with shipments to the U.S. military down 12% and lower demand from U.S. data center customers. Our international revenues declined by 11% in 2015. In Brazil, our revenues decreased 48% due to a 50% reduction in truck production as the economy fell into recession, and a more than 30% depreciation of the real against the U.S. dollar. Revenues in our Power Generation and Distribution business fell less than in our on-highway business but conditions remain very challenging in all end markets. Our full-year revenues in China including joint ventures were $3.3 billion in line with 2014 as we significantly outperformed very weak end markets. Industry demand for medium and heavy duty trucks in China decreased by 24% for the full year as the industrial economy slowed. Our market share reached 18% in the fourth quarter of 2015, taking our full-year market share above 16% and up 460 basis points compared to 2014. This represents significant achievement in a very competitive market. In addition, our Components business capitalized on the transition to NS4 emission standards delivering 17% revenue growth, despite the sharp decline in market size. Shipments of our light-duty engines in China increased by 5% in a market that declined 6% as Foton increased the proportion of its trucks powered by our joint venture engines displacing local competitor engines. Our full-year share in the light duty truck market exceeded 6% in 2015, up 140 basis points. Cummins' share of earnings from our joint ventures with Foton increased by $60 million in 2015. Our heavy duty engine joint venture was consistently profitable from the second quarter onwards, less than a year after production started there. Industry demand for excavators in China dropped 38% in 2015, the fourth consecutive year of decline and demand for Power Generation equipments dropped more than 10% due to weaker infrastructure investment. Our revenues in both markets declined a little less than industry demand. Full-year revenues in India including joint ventures were $1.5 billion, a 15% increase over 2014. Industry truck production increased 28% to 318,000 units, and our market share was 41% versus 42% a year ago. Our penetration within Tata Motors increased year-over-year, however this was offset by a decline in Tata's truck share. Revenues for our Power Generation business increased by 6%, in line with the pace of the economy. Now, let me provide our overall outlook for 2016 and then comment on individual regions and end markets. We're currently forecasting total company revenues to decline by 5% to 9%, driven by a decline in heavy duty truck production in North America, continued weakness in global off-highway and Power Generation markets, and further strengthening of the U.S. dollar against a number of currencies. Industry production for heavy duty trucks in North America is projected to be 220,000 units, a 25% decrease year-over-year with our market share projected to be between 30% and 33%. In the medium duty truck market, we expect the market size to be 124,000 units or flat compared to 2015. We project our market share to be between 72% and 75%. Our engine shipments for pickup trucks in North America are expected to increase by 12%, reflecting strong demand from Chrysler and a ramp-up in sales to Nissan. In China, we expect domestic revenues, including joint ventures, to be flat again in 2016 with market share gains in heavy and light duty truck markets helping to offset weaker market demand. We expect that our full-year market share in the heavy and medium duty truck market will exceed 18% for the full year and that we will achieve 8% share of the light duty truck market. We expect demand in most end markets in China to be down 10% with industry truck market sales of light and heavy duty trucks combined expected to decline by 4%. In India, we expect total revenues including joint ventures to increase by 4% in 2016 with stronger demand in most end markets partially offset by depreciation of the rupee against the U.S. dollar. We expect the truck market to grow by 8% in 2016 and continue to outpace the recovery in off-highway markets. The government of India is strongly promoting investment in infrastructure, which will be positive for our power generation, construction and rail businesses. However, the pace of new projects achieving full approval and moving forward has been slow. We are optimistic that the economy in India will continue to improve in 2016, and we are best positioned to benefit as investment increases and demand for capital goods picks up. In Brazil, we expect truck production for 2016 to decline by up to 20% as the country remains in recession. At some point, we will see a return to growth in Brazil, but that appears unlikely in 2016, given the current economic challenges. As a result of weak commodity prices and lower capital spending by energy and mining companies, we expect demand for our high horsepower engines to decline again in 2016. In aggregate, we expect a 4% decline in Engine revenues. Sales of our new QSK95 engine will add more than 5% to higher horsepower engine sales in 2016, but will be more than offset by weaker sales in most markets. Due to weak or slowing demand in many of our major markets, 2016 will be another challenging year. As I said, we expect sales to decline by 5% to 9% and we expect EBIT margins to be in the range of 11.6% to 12.2%, resulting in 25% decremental margins at the midpoint of our guidance. Strong performance in cost reduction initiatives drove gross margin improvement in 2015 despite weaker sales. Through our restructuring actions and ongoing initiatives to reduce material cost and improve quality, we expect to deliver even more savings in 2016 as Pat will cover in more detail. We did complete the reduction in professional head count in the fourth quarter as planned and have already taken a number of actions within our manufacturing plants to lower costs. We have announced our plans to close a generator assembly plant in India, an alternator plant in Mexico, and there will be at least one more significant announcement in the near term. Finally, as discussed at our Investor Day, we plan to return 50% of operating cash flow to shareholders over time, but that we may return more or less in any given year depending on business needs and market conditions. In 2016, we plan to return 75% of operating cash flow to shareholders, building on our record $1.5 billion we have returned in 2015. Thank you for your interest today, and now I'll turn it over to Pat, who will cover our 2015 performance and our 2016 guidance in more detail.

Patrick J. Ward: Thank you, Tom, and good morning, everyone. I will start with a review of the full-year 2015 financial results before moving on to our fourth quarter performance. As Tom has already discussed, we recorded restructuring and impairment charges totaling $301 million pre-tax or $194 million after-tax in the fourth quarter. In order to focus on the operational performance of the business, I am going to exclude these items and the $32 million of cost reduction activities in the Power Generation segment incurred in the fourth quarter of 2014 in my following comments. Full-year revenues for the company were $19.1 billion, a decrease of 1% compared to the prior year. Increased revenues from the acquisitions of our North American distributors along with higher demand in North American on-highway markets, were more than offset by a decline in global off-highway demand, weaker demand in the Brazilian truck market, and the unfavorable currency impact from the stronger U.S. dollar. Revenues in North America improved 7% in 2015 and represented 61% of total 2015 revenues, up from 56% last year. International revenues declined by 11% compared to 2014, with lower sales in Latin America, Europe, and Russia, and in most regions in Asia with the exception of India. Unfavorable currency movements negatively impacted full-year sales by approximately 4% or over $700 million. Gross margins of 25.9% were 50 basis points higher than in 2014, with improvements in material cost and in warranty more than offsetting the negative impacts of product mix and from currency movements. Selling, admin, and research and development cost decreased by $12 million in the year and were flat as a percent of sales, despite the acquisitions in our Distribution segment which added $86 million in expense. Joint venture income decreased $55 million compared to last year with higher earnings from our Foton-Cummins joint venture in China more than offset by the impact of distributor acquisitions in North America. A combination of other operating expense and non-operating income was $161 million lower than last year, most of which relates to the $60 million loss contingency, $55 million in lower fair market value gains on the consolidation of our distribution joint ventures, and $27 million from the gains recorded last year from changes in the cash surrender value of our corporate-owned life insurance policies. In total, earnings before interest and tax, or EBIT, was $2.4 billion or 12.5% of sales, down from $2.5 billion or 13.2% of sales in the previous year. Foreign currency negatively impacted EBIT by approximately $95 million. Net income was $1.6 billion or $8.93 a share, excluding the asset impairment and restructuring charges. This compares to $1.7 billion or $9.13 per share in 2014. And the operating tax rate for the full year came at 27.4%. Now, let me comment specifically on the fourth quarter and provide some more details on our performance there. Fourth quarter revenues were $4.8 billion, a decrease of 6% from a year ago. Currency movements reduced sales by 4%, while distribution acquisitions added approximately 1.4% to sales. Sales in North America represented 60% of our fourth quarter revenues but declined 2% from a year ago, due primarily to lower demand in heavy duty truck, construction, oil and gas and power generation markets. International sales declined by 12% compared to the prior year with the biggest contributors being very weak demand in Latin America and the negative impact of currency movements. Gross margins were 25.4% of sales, which is the same as a year ago, as improvements to warranty costs and material costs offset the negative impact of lower volumes, currency, and unfavorable product mix. Selling, admin, and research and development costs of $685 million or 14.4% of sales, decreased $60 million from a year ago and were 20 basis points lower as a percent of sales. Joint venture income of $75 million decreased by $1 million compared to last year. Increased earnings in China primarily due to the introduction of new products and market share gains in top markets were offset by the impact of acquiring our North American distributors, which were previously held as joint ventures. A combination of other operating expense and non-operating income decreased by $104 million. The main driver of this change was the provision for a loss contingency in 2015 and the one-time fair market value gains on distributor acquisitions recorded in the fourth quarter of 2014. Earnings before interest and tax were $531 million or 11.1% of sales for the quarter compared to $661 million or 13% of sales last year. Foreign currency negatively impacted EBIT by $34 million. Net earnings for the quarter excluding the asset impairment and restructuring charges were $355 million or $3.02 per diluted share compared to $2.56 in 2014. The all-in tax rate of 16% in the quarter included a $25 million benefit from the research and development tax credit that was passed late in 2015. Moving on to the operating segments, let me summarize their performance in the fourth quarter, their results for the full year of 2015 and then provide our current projections for 2016. I will then review the full-year cash flow and conclude with the company's revenue and profitability expectations for the upcoming year. In the Engine segment, revenues were $2.5 billion, a decrease of 11% from last year. Off-highway revenues declined 22% due to weak global demand for engines in construction, marine, and oil and gas markets. On-highway revenues declined by 5% as production in the North American heavy duty truck market declined compared to a strong quarter in 2014. Segment EBIT was $189 million or 7.5% of sales compared to 11.1% last year. Excluding the loss contingency, EBIT was 9.8% in the quarter. Improvements in material costs and lower warranty expenses were more than offset by the impact of lower volumes and unfavorable product mix. For the full year revenues decreased 5% from the year ago and earnings before interest and taxes declined from 11.2% to 9.9%. For the Engine business in 2016, we expect revenues to be down by 5% to 9%. Industry production for heavy duty trucks in North America is expected to decline by 25%. We expect global industrial revenues will decline due to lower demand in construction and in marine markets. In 2016, we will begin to see increased sales of our largest engine, the QSK95, which will help us outperform a weak market for high horsepower engines. We expect full-year high horsepower engine volumes to decline by 5%. 2016 EBIT margins are expected to be in the range of 9% to 10% of sales compared to 9.9% of full-year 2015. The benefits from restructuring, more material costs, and higher joint venture earnings from China will help to offset the negative impact of the lower volumes. For the Distribution segment, fourth quarter revenues were $1.7 billion, which increased 1% compared to the prior year. Acquisitions added more than 9% to segment revenues year-over-year, partially offset by a 6% negative impact from foreign currency. Organic sales declined by 2% due to weak off-highway markets. EBIT margins for the quarter decreased from 9.3% to 6.5% with foreign currency movements negatively impacting margins by 200 basis points. In addition, in 2014, we recorded $33 million of one-time, fair market value gains on the acquisitions which should not repeat in the fourth quarter of 2015. Improvements in existing operations added 60 basis points to margins despite lower organic sales. For 2015, the Distribution business delivered record sales, up 20% compared to 2014. EBIT as a percent of sales declined from 9.5% to 7%. Currency negatively impacted earnings by $127 million, lowering the EBIT percentage by 200 basis points. In addition, we recorded $55 million less in one-time fair market value gains compared to the previous year. For 2016, Distribution revenue is projected to be flat to down 4% due to weak demand in off-highway markets and from the negative impact of the appreciating U.S. dollar. We expect EBIT margins to be in the range of 6.25% to 7.25% of sales. The Components segment recorded sales of $1.2 billion, a 6% decline from the year ago. Compared to the fourth quarter of last year, lower demand in the North American and Brazilian truck markets along with negative foreign currency impacts led to the sales decline. Sales in China were up in the fourth quarter by 12% and up 17% for the full year despite significantly weaker market demand as we continue to capture benefits from the transition to more advanced emission standards. Segment EBIT was $175 million or 14.2% of sales, an increase of 210 basis points, due primarily to strong execution on cost reduction initiatives, which more than offset lower pricing. 2015 was a record year for our Components segment in terms of revenues, EBIT dollars, and EBIT percent. Revenues were up 1%, and EBIT improved from 13.4% to 14.5% of sales. Looking forward into 2016, we expect revenue to decline by 6% to 10% as a result of weaker demand in North America. And EBIT is projected to be in the range of 12.75% to 13.75% of sales. In the Power Generation segment, fourth quarter sales were $654 million, down 14%, reflecting continued weakness in global markets. Year-over-year international sales decreased 15% with Latin America accounting for half of the decline. Sales in North America were down 12% due to lower military sales and softer demand from data center customers. EBIT margins were 4.1% in the quarter, down from 7.1% last year. Lower sales volumes, adverse mix, and lower pricing contributed to the lower EBIT margin, along with inventory write-downs due to very weak demand in some specific segments of the business. For the full year, Power Generation revenues were down 5% from 2014, and EBIT margins dropped from 6.9% to 6.4% of sales. For 2016, we expect Power Gen revenues to decline by a further 3% to 7% with continued weakness in most major markets. EBIT margins are expected to improve in 2016 to between 6.5% to 7.5% as the benefits of restructuring and other cost reduction initiatives more than offset the impact of the lower volumes. As Tom mentioned, we are projecting total company revenues to be down 5% to 9% in 2016. Lower levels of production in the North American heavy duty truck market, reduced demand globally for off-highway and Power Generation equipment, and continued pressure from the strong U.S. dollar will drive the majority of the reduction in revenue. The introduction of new products and increased revenue from distribution acquisitions will add between 1% and 2% to our revenues. Joint venture income is expected to be flat compared to 2015 with some improvements due to market share gains in China offset by weaker off-highway demand. We expect EBIT margins of between 11.6% and 12.2% for 2016 which compares to 12.5% in 2015. At the midpoint of the guidance, we expect to generate $300 million of cost savings that would partially offset the negative impact of lower volumes, currency, pricing, and unfavorable product mix, and will help contain decremental EBIT margins to 25%. The $300 million of savings will result from the benefits of restructuring actions, material cost reduction initiatives, and lower warranty costs net of targeted investments. We are currently projecting our tax rate to be approximately 28.5% in 2016, excluding any discrete items compared to 27.4% in 2015. And finally, let me turn to cash flow. In the fourth quarter, we reduced inventory by $352 million as we aligned production to the lower levels of demand. The improvement in inventory contributed to a positive $928 million in cash from operations in the fourth quarter. For the full year, we generated $2.1 billion in cash from operating activities, the third straight year above $2 billion. We continue to use our cash to reinvest back into the company and to return value to our shareholders. We returned 74% of the cash generated from operations to our shareholders in 2015. We increased our dividend by 25%, and we repurchased 7.2 million shares for a combined total of $1.5 billion, up 29% over the amount returned in 2014. We also continue to invest in the business with $744 million in capital expenditure projects in 2015 and $117 million for acquisitions. We anticipate operating cash flow performance in 2016 will be within our long-term guidance range of 10% to 15% of sales. Capital expenditures are expected to be in the range of $600 million to $650 million. We will continue to repurchase shares and as we indicated at our Analyst Day last November, we plan to return 75% of operating cash flow to our shareholders through dividends and stock repurchases in 2016. Now, let me turn it over to Mark.

Mark Smith: Okay. Now, we're ready for the Q&A portion of the call. Operator, we'll turn it over to you, please. Please try and limit your first question and a related follow up and then get back in line if you can. Thank you.

Operator: Our first question comes from Adam Uhlman of Cleveland Research. Your line is now open.

Adam William Uhlman: Hi. Good morning.

N. Thomas Linebarger: Good morning, Adam.

Patrick J. Ward: Morning, Adam.

Adam William Uhlman: Pat, I was wondering if you could walk us through your currency assumptions for 2016 by segment in terms of the earnings impact. I know it's not terribly huge for the year, but there are some moving pieces. And then related to that, if you could build out on your comments on the material cost savings that you expect for the year, I think that would be helpful. Thank you.

Patrick J. Ward: Okay. So on foreign currency, Adam, just now we're projecting for the company, somewhere between a $250 million and a $300 million negative impact on the top-line and between $30 million and $40 million negative impact on the bottom-line. The segment that's always most impacted by this is Distribution, and for Distribution, from memory, we're looking out into $100 million dollars of negative impact on the top-line and somewhere around $25 million on the bottom-line. And then your question on material cost, last year, we had a terrific performance last year in our supply chain organization. We reduced material costs by 1.5%. That was a margin benefit of almost $300 million. This year, we're projecting closer to 1%, which would be around $180 million.

Adam William Uhlman: Great. Thank you.

Operator: Thank you. Our next question comes from the line of Jerry Revich of Goldman Sachs. Your line is now open.

Jerry Revich: Good morning, everyone.

N. Thomas Linebarger: Good morning, Jerry.

Patrick J. Ward: Good morning, Jerry.

Jerry Revich: I'm wondering if you folks can just flesh out for us the Power Gen expectations that you laid out for 2016, which is pretty good margin performance in context of the sales decline. Maybe just help us understand where the cost savings are coming from and how should we think about decremental margins if sales are at the low end of your sales range or another 5% to 10% lower, what levers would you be able to pull in that business?

Rich Freeland: Hey, Jerry. This is Rich. Just a reminder on how – on 2015, we initiated a lot of cost reduction towards the end of 2014, and in 2015, we realized 16% decremental margins, which is a little bit better than what our normal 25% that we would say. What we're committed to in 2016 actually is to increase margins on reduced sales. And so probably three major areas, but one is the restructuring work that we kicked off before we'll get a full-year impact to that in 2015. The actions we took in Q4, for example, let's say a 7% professional head count reduction was much heavier in the Power Gen business, so exceeded 10% in the Power Gen business. Tom mentioned that some plants restructuring that we've done, that was all in the Power Generation business. And again, we're looking to further actions in that area. So we feel confident, even with the lower sales levels, that will in fact increase EBIT going forward in 2016 with those actions.

Jerry Revich: Okay. Thank you. And then on the new hedgehog engines, can you talk about the range of applications where the product has been that rolled out, and will run through the production line for 2016? And how should we think about the range of applications picking up for 2017? And if you're willing to comment on the tailwind that you'll get in 2017 if you hit those milestones compared to the 5% you spoke about for 2016 that would be helpful. Thank you.

Rich Freeland: Okay. Yes. So we're ramping up right now. We're in the process of building four a week, and so we'll be at that level roughly at the end of the first quarter. The sales to-date are almost – well, currently are all Power Generation. And in particular, a lot of standby and a lot of data center. And so we have in fact exceeded our numbers and really sold out for a good part of the year there. In Q3, we'll begin our first rail business, the business is secured, and it will go into production. And in fact, we've secured our first marine business that will go into business in Q4. It's small numbers. I think we'll sell 10 this year in the marine, and a smaller number, I think maybe 20 or 30 in the rail side. I can confirm that. So predominantly the Power Gen is where the sales are, and primarily in the data center area.

Jerry Revich: And, Rich, are you willing to comment on 2017?

Rich Freeland: Again, we're just – we'll continue to grow from there. So we're actually gaining share in particular in the data center business, where we're now getting about 30% of the new business we're getting, we're very optimistic that we'll move that beyond 50% as that business continues to grow. And then the rail and the marine will both continue to ramp up.

Jerry Revich: Okay. Thank you.

Operator: Thank you. Our next question comes from Steven Fisher of UBS. Your line is now open.

Steven Michael Fisher: Thanks. Good morning. Tom, you mentioned the 90 basis points warranty cost improvement with more expected in 2016. Can you just give us a sense for how much more runway you have on that and whether it's material?

Patrick J. Ward: Let me jump in here. Yes, so in 2016, just now we're projecting 20 basis points improvement. So we came down to 2.2% of sales in 2015, and within our current guidance we're assuming 2% at this stage for 2016.

Steven Michael Fisher: Okay. And then a question on China, looking at slide 40. Where do you think the China market and sales of your various products in China will be in 2016 relative to normalized levels of demand there?

N. Thomas Linebarger: Normalized levels of demand are getting harder and harder to figure out, frankly. There is a couple of things going on in China. One, you know obviously is that from an economic point of view, there is a shift going on from what was largely an industrial and export economy to some more balanced economy; at least that's what they're trying to do. So almost all of our markets are declining even as the economy grows. And that's just a reflection of that shift. We provide a lot to infrastructure in those kind of segments. And second thing that's going on of course is efficiency improvements. So in the truck market for an example, the number of trucks sold in its peak, it's not clear that we'll ever hit that number again. It kind of depends. The efficiencies are improving, but so is the potential. So many parts of China where there is not much infrastructure built yet, the government is likely to build more infrastructure there. So it's kind of hard to know, frankly, from our point of view, you know, which – right now the trends are efficiency is improving faster than growth, which again, why we're seeing shrinkage in the market for trucks, for example. But our view is that as the economy begins to grow and industrial begins to grow more, we'll see more expansion of the market overall. But all that is a long way of saying we don't exactly know what the peak looks like again. Here is what we do know, is that as they have increased their focus on emissions out of their equipment and the quality, the demand for quality, and more professional fleets and operators increases, the demand for our products is increasing. So as a percentage of the total trucks sold, our market share continues to increase, and we are benefiting significantly from that along with our partners there. And that is primarily a truck phenomenon today, but my expectation is that will be across all segments in China over time.

Steven Michael Fisher: Great. Thanks a lot.

Operator: Thank you. Our next question comes from Jamie Cook of Credit Suisse. Your line is now open. Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker) Hi. Good morning.

N. Thomas Linebarger: Good morning, Jamie. Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker) A couple of questions, first. Tom, I'm just trying to get a sense, at your Analyst Day I think you said, or last time you commented on 2016 you said sales down 5%, now down 5% to 9%. I'm just trying to get a sense for what markets have deteriorated further versus your expectations? Because I would have assumed you would have known that the U.S. truck was rolling, I mean, at that point. So I want to get a sense for what's sort of changed? And are you seeing that – seeing any – are there any different results I guess as you look at January? And then my second question is to Rich. I know Jerry asked about your Power Gen margins and your Power Gen margins improving in a modest sales decline in 2016. I guess the flip side to that is at the Analyst Day you talked about Power Gen margins doubling, I mean hitting I think the double-digit range on sort of lower sales, and I think you even said over two years. So I'm just trying to get an update there? Or is that largely relying on Hedgehog? Or how to think about that? Thanks.

N. Thomas Linebarger: Good. Thanks, Jamie. I'll do the first one. So as you remember from our Analyst Day, I said sales will be down at least 5%. But nonetheless, there is no question that from our point of view, things that were rough like the truck market, which we haven't really changed our outlook very much on, stayed rough and the things that maybe could have flattened out or got better did not. So all the resource markets look worse, not better. FX looks worse, not better. So again, what – as we're rolling through these things, you never know which things might start to bottom out. And right now nothing seems to be that way. So really there is no major shift in any one market. What I'd say is all things we are concerned about, our concern turned out to be well founded, and the things that could maybe have stabilized hasn't really yet. So again, we're operating in that environment. You know we've been there before. We're an urgent and flexible operator in this environment, so I wish it wasn't this, but I think we'll do relatively well because we will react quickly. I gave the example of our Jamestown Engine Plant which is already down to the levels of production that we expect for this year and we'll produce efficiently at that level. So hopefully we'll do well compared to the circumstances, but there is no question that the market circumstances are everything we expected when we talked on our Investor Day and slightly worse on those couple of things I mentioned, FX and just the general large engine area. Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker) Thank you. And then on Power Gen?

Rich Freeland: Yes. So yeah, we talked about or what I talked about was on flat sales over a two-year period getting to double-digit profitability. And so that's still the path for auto although we're seeing sales maybe could be worse than flat to what you're seeing in 2016. But the actions are the same. So – and there's maybe in three areas, so one is the plant savings, so some of the restructuring work we've done in plants and are continuing to do, the two plants that we already announced and some more stuff to come, those will play out over a couple of years. You don't get the savings immediately like you do with the restructuring of overhead savings. So the plant savings are yet to come. We've continued, we've hit hard on the overheads reductions. And we're continuing some work in there on how we do work in the Power Gen business. So less about taking a lot of people out, significantly increasing the efficiency of how we get after quality, how we bring products to market faster, and that will again be a piece of it that will play out over the next two years. And then lastly, the hedgehog will be another tailwind that we'll get. So we've only really started on that with small numbers in 2015, that begins to ramp up in 2016 and will accelerate moving forward. Jamie L. Cook - Credit Suisse Securities (USA) LLC (Broker) Okay. Thanks. I'll get back in queue.

N. Thomas Linebarger: Thanks, Jamie.

Operator: Thank you. Our next question comes from Ross Gilardi of Bank of America Merrill Lynch. Your line is now open.

Ross P. Gilardi: Yeah, good morning.

N. Thomas Linebarger: Hey, Ross.

Ross P. Gilardi: Just a couple of questions. So on Engine, you guys are guiding to down 5% to 9% on the back of 10% to 11% declines in the second half of 2015 seemingly just as North America truck production is really rolling over. So I'm trying to understand why you would assume that the pace of decline actually eases in 2016 versus the current run rate. And I'm also just trying to put a 5% to 9% revenue decline in the context with a 25% cut to North America truck production.

N. Thomas Linebarger: Yeah, I can start and Rich can finish it. Again, at broad levels, as I mentioned, the truck production started in the second half for us. So the pace that you're talking about, were a lot of that in the second half of the year, not all of it, but a lot of it. And second, I mean, the big tailwind for us is new products. And, again, you've heard about what many of those new products are, but we had some – that's really the only tailwind we see. So most of the markets as you mentioned are declining. They're not – the pace of decline might be slowing down in some markets, for example, on the off-highway markets. Although they're still declining, which is remarkable, they are declining slower and again we boar a lot of the decline of the truck market in the second half. So we consider it still quite a tough environment, but as you said the decline is decreasing some. And then the new products are offering us opportunities to grow in some segments. Rich, anything you would add in new products?

Rich Freeland: I don't think so. Just to give – put a couple of numbers behind what Tom said. So end of the year in the North America truck, at about a 250 market size. So that's what the industry was producing at. So we've seen some of that reduction while we were 290 for the year, we're already down to 250 in Q4, and so we're projecting 220 going forward. And then on the new products, we'll generate approximately $300 million in sales between the pickup business and the hedgehog to offset some of that.

Ross P. Gilardi: Got it. Thank you. And then just somewhat related to that, I mean you've got Components down 6% to 10% versus Engines down 5% to 9%. I mean, I think this will be the first year in a while that Components would actually underperform Engines from a revenue standpoint. And can you give us a little bit more of background on the thinking there?

N. Thomas Linebarger: It's just regional. It's just regional weighting. We just have more North America in Components than you do in the Engine business a little bit more. And so they're feeling the effect of North America truck a little bit more than the Engine, even though you think of us as Engine in North America. In fact Components is a little more weighted there. Again, that'll change over time, but today given the way the emissions regulations are there're just more equipment required from the Components business in the North American truck than a Chinese or an Indian truck.

Ross P. Gilardi: Got it. Thank you.

Operator: Thank you. And our next question comes from Robert Wertheimer of Barclays. Your line is now open.

Robert Wertheimer: Good morning, everybody.

N. Thomas Linebarger: Good morning, Rob.

Robert Wertheimer: So I guess my question is on decremental margins and the impact of emerging markets. And so there has been pockets of more severe volatility, let's say, I use Brazil as an example, where seemingly it gets harder and harder to measure to perform to margin level as your margins fall further and further. On the other hand, some of it's already in there. So I wonder if you can tell us if that sort of rings sense by now where you know what your margins are or are going to be given more extreme downturns, whether as an example Brazil whether that's still profitable or not? Or whether you can stop at breakeven? And just whether that's a risk that's sort of already played out, or whether that volatility in the emerging markets continues to put downside risk on decrementals (49:32)?

Patrick J. Ward: Okay. So I think at least for us the three biggest emerging markets are China, India and Brazil. So in China, as Tom said, we've been doing far better than the end markets sort of picking up share and content. So I guess, we're holding steady in a very difficult environment. We seem underpinned there with the penetration from new products. India, the economy is improving, maybe not quite at the rapid pace we thought, but we saw improvement last year, some market set for improvement, government is pushing infrastructure investment. So I think again we're cautiously positive on India. Brazil, as you pointed out, is really, really tough. Unfortunately, right now, I think it's less than 2% of our consolidated sales, and we've taken maybe four or five rounds of actions that we haven't necessarily called out on these calls to lower our cost base. So yes, the cost, there still could be some downside impact if revenues fall further, but I think given the reason I've just explained, in two out of the three regions, we're cautiously optimistic about maintaining or improving performance.

Robert Wertheimer: Very helpful. Thank you.

Operator: Thank you. Our next question comes from Joe O'Dea of Vertical Research. Your line is now open.

Joe J. O'Dea: Hi. Good morning.

N. Thomas Linebarger: Hey, Joe.

Joe J. O'Dea: Just back on heavy duty truck revenue, could you talk about with it down 20% expectation in 2016, within that, what's your thinking in terms of market share? And then also it appears that in 4Q aftermarket was also a nice offset to some of the Engine volume headwinds, what you anticipate for aftermarket trends in 2016 on heavy duty truck?

Rich Freeland: Sure. I'll go ahead and start here. So on the market share, we ended up right at 33% for the year, but lower in the back half of the year compared to the front half of the year. And we really finished the last six months in the 31% to 32% range. So with the numbers we have given you for targeting sales, both market size and share, is we've targeted in the 30% to 33% range. So kind of the midpoint of 31.5%, which is where we've leveled out. You get a lot of month-to-month or even quarter-to-quarter variation. It's important to not overreact to that. But I think the ongoing trends kind of have us in that 30% to 33% range.

Patrick J. Ward: And aftermarket across the company we're planning on pretty flat levels in 2016.

Joe J. O'Dea: Okay.

Rich Freeland: Yeah, for Engine, freight activity remains good. So the parts sales in particular in North America remain very solid.

N. Thomas Linebarger: Yeah. And the Q4 was not a particularly – parts was not a big offset to engine problem. We had some parts where parts were good, and in some parts, parts were not so good, like in off-highway they were actually pretty bad. So, so far, the big opportunity we have is now that we've done this – these distributor acquisitions and we've put together these distributors for the first time, we have in front of us the opportunity to capture share and other synergies in the aftermarket and service market. The risks we have is that as the large engine markets, mining and others, continue to suffer, more and more of those customers are figuring out ways to do less service, spend less money on parts, because they're really struggling. Obviously that – which is not good for our parts business.

Joe J. O'Dea: Got it. And then just a question on pricing. I think you mentioned within Components that some of the cost actions that you had taken were responsible for driving the margin up sequentially with a little bit of price pressure offsetting that. Could you just quantify at all what you were seeing in terms of price if that was accelerated from what you've seen in terms of price pressure in the past and kind of outlook for 2016?

Patrick J. Ward: It's not accelerated. So a lot of our pricing arrangements are structured through our long-term agreements. So it's not what I'd call unplanned pricing. So we're talking fractions of 1% of lower pricing, which was comfortably offset by the material cost savings across the company, and again it's going to be both fractions of a percent, little less than 50 basis points of a headwind going into 2016 across the company.

Joe J. O'Dea: Great. Thanks very much.

N. Thomas Linebarger: Thank you.

Operator: Thank you. Our next question comes from Nicole Deblase of Morgan Stanley. Your line is now pen.

Nicole Deblase: Yeah, thanks. Good morning, guys.

N. Thomas Linebarger: Hi, Nicole.

Nicole Deblase: Hi. So my first question is around free cash flow allocations. You guys mentioned that you're going to return about 75% of operating cash flow in 2016. Does that imply that we shouldn't expect any material acquisitions, or is the right way to think about it the pipeline is still active, you're looking, and you would be willing to take down the operating cash flow payout ratio if you saw something that fit what you're looking for?

N. Thomas Linebarger: Nicole, this is Tom. As we talked about at the Investor Day, our view is that our operating cash flow and the flexibility in our balance sheet gives us the opportunity to do the strategic part, which includes acquisitions and partnerships as we discussed there even with this kind of payout. I mean, we talked about 50%, but we feel the same way with 75%, especially for a one-year or a two-year kind of time. And so we're feeling completely able to do the things that are in our strategic plan that I talked about there. And we are very active on that. So you probably know I can't announce anything until I have something to announce, but the fact is we are – I'm significantly involved in those, we have significant resources looking at those strategic growth opportunities. So we are plowing straight ahead and this change to the 75% has no impact on that strategy. So we – and again, as you stated there, we would make a change to how much cash we gave back if we felt that was a good thing for shareholders and we had a clear growth strategy, profitable growth strategy to support it. But right now we feel like we have enough room in cash flow and debt capacity that we won't probably be talking about that in the short run.

Nicole Deblase: Okay. Got it. That's really helpful. Thanks, Tom. And then for my follow up, just with respect to restructuring, so you guys are sticking to the $160 million of payback for 2016, if conditions were to deteriorate further or come in maybe even at the low end of your range for 2016, do you see scope for additional restructuring, or do you think you've already kind of attacked what needs to be attacked?

N. Thomas Linebarger: Yes, there is always – unfortunately, always room for further restructuring. I think the thing you've heard from us is that our – we find a way to do well in good and bad times, whenever they face us. And we want to do that quickly and with urgency and so that's what we're going to continue to do. We want to make sure we take our actions not in a kneejerk way, in a sensible way that leads to long-term performance of the company. But under the circumstances, we obviously had to make adjustments because conditions are weak. And if they got significantly weaker, we'd do what we needed to do to make sure that we continue to generate strong financial results even in the face of that. But right now we feel like, to Jamie's question earlier, we understand where the markets are. We fully take them into consideration, and we're on the right plan to do it. And you also heard from Rich, we have a little bit more to announce in the Power Gen side, but we think at that point, we're at the right spot. But if conditions change, we'll react accordingly.

Nicole Deblase: Okay. Thanks. I'll pass it on.

N. Thomas Linebarger: Thank you.

Mark Smith: Probably time for one, two questions.

Operator: Thank you. Our next question comes from the line of Alex Potter of Piper Jaffray. Your line is now open

Alexander Eugene Potter: Thanks.

N. Thomas Linebarger: Hello, Alex. Good morning.

Alexander Eugene Potter: I guess I had – both my questions were focused on some of these one-time charges. So first there was the asset impairment charge on the V8 product line. Just wondering, I mean it sounds like if that extra customer you had been shooting for, sounds like they went another way, another direction. So does that mean you're just going to be left with a facility that's less utilized than what you had originally hoped?

Rich Freeland: Okay. Yes, Alex. Well, a couple of things. On the – so this is the line for the LDD, the 5-liter V8 production line that we had. And so we signed up and we're doing the Nissan business there. We had in fact been looking at a couple of different options: one, some other customers; two, potential pickup customers, and we'd actually looked inside our own business and were going to expand our own product line. In light of the current economic situations, both of those are less likely in the short term. And so I mean, just the financial criteria requires that you write-down the asset if that's the case. It's just the probability of doing that. So it's a noncash write-down of the assets. But just kind of remind you a couple of things that don't change or are actually not – the line remains intact. We're not actually getting rid of any assets. We're moving forward with the Nissan business, which in fact we're very excited about. We've sold over 4,600 to-date. The industry feedback is good. Last time I looked I think we had six either truck of the year or powertrain of the year awards. The customer feedback, as we've talked to and is getting written up kind of on the Internet, is positive. Nissan dealers are excited about it. There is a lot of flow into their shops. So we're going to continue to use that line to do that. In fact, we'll continue to look for additional customers. In fact, we'll add some non-pickup customers in 2016 on the line. But again, the book value of the line was being written down is really the only change.

Alexander Eugene Potter: Okay. Very good. And then just sliding one more in here on the one-time items, you had a loss contingency quality issue. It sounds like it was mostly somebody else's fault. Just trying to, I guess, get an idea of your confidence that something like this won't or can't recur with some other OEMs. Thanks.

N. Thomas Linebarger: Thanks for that, Alex. In this, first of all, let me just say that from our point of view our place here is trying to make sure that our customers think that our products and our customers' products are the best and at the highest performing choice they have. So when there is an issue like this one, our goal is to make sure that customers are – we address the customer issue as quickly as possible. And in this case, as we mentioned, we're the certificate holder in the engine, we're taking the lead, irrespective of whose view we think caused what. We're in there making sure customers are whole, we're making sure that the product performs properly. So that's what we're doing here. And we'll work out the rest later. It's a single application. It's a pretty narrow range of products. But it's important that we resolve it quickly. That's why we have it here. And as you mentioned, it's the reason it's sort of held in a different line than we normally would hold product quality or warranty is because it's not on a product that we actually technically produce. In my judgment and the rest of this group, it's a product quality issue or a system quality issue that we're trying to make right with our partners, and we're going to do that. But it technically needs to be held in a different part of the (01:01:25) because we don't actually manufacture that system, and therefore we cannot accrue warranty the way we would anything else.

Alexander Eugene Potter: Okay.

Rich Freeland: It's worth repeating it that, we have no other commercial agreements like this. And this is unique in the company where we have a third party after treatment attached to our engine.

Alexander Eugene Potter: Okay. Very helpful. Thanks a lot, guys.

Patrick J. Ward: Okay. I think we've exceeded our time. So thank you very much for your interest today. And I'll be available for calls later.

Rich Freeland: Thank you.

N. Thomas Linebarger: Thank you.

Operator: Ladies and gentlemen, thank you for your participation on today's conference. This concludes your program. You may now disconnect. Everyone, have a great day.