Good day, ladies and gentlemen, and welcome to the Cummins Inc. First Quarter 2017 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded..

I would now like to turn the call over to Vice President of Financial Operations, Mr. Mark Smith. Please go ahead, sir. .

Thank you, Andrew. Good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the first quarter of 2017. Joining me today are our Chairman and Chief Executive Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and our President and Chief Operating Officer, Rich Freeland.

We'll all be available for your questions at the end of the prepared remarks..

Before we start, please note that some of the information you will hear or be given today will consist of forward-looking statements within the meaning of the meaning of Securities and 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 on the forward-looking disclosure statement in the slide deck and our filings with the SEC, particularly the Risk Factor section of our most recently filed annual and quarterly reports..

During the course of this call, we will be discussing certain non-GAAP financial measures, and we refer you to our website for the reconciliation of those measures to GAAP measures.

Our press release, with a copy of the financial statements, and a copy of today's webcast presentation are available on our website at cummins.com under the heading Investors and Media..

Now I'll hand it over to Tom. Thank you. .

Thank you, Vice President Smith. Good morning, everyone. Today, I'll provide you a summary of our first quarter results as well as some comments on our outlook for 2017. Pat will then take you through more details of both our first quarter financial performance and our forecast for the year..

But before I provide my comments in the quarter, I'd like to talk about a recently announced agreement with Eaton, to form a joint venture to design, develop and manufacture automated transmissions.

We are very excited about this joint venture with Eaton, and we have provided some additional slides on our website, which lay out why this joint venture presents a significant opportunity for Cummins. .

The strategic rationale for the joint venture is simple. Since fuel is one of the largest cost drivers for our customers, fuel efficiency will be a primary differentiator of commercial powertrains across our global markets.

Cummins and Eaton have been partners for decades and today, offer the leading combination of engine and transmission performance in the North American heavy-duty truck market.

We believe that the next-generation of transmissions designed, developed and manufactured by the joint venture, combined with Cummins capability and system integration, can yield significant improvements in fuel efficiency for Cummins and our OEM customers and partners..

Cummins will invest $600 million for a 50% share of this joint venture.

And in return, we'll be able to develop integrated powertrains that offer a significant performance advantage, add to our portfolio of technology offerings to our customers and benefit from the value created by the joint venture as it leads the secular shift to more automated transmissions. .

Eaton will contribute the current design for the next-generation heavy-duty automated manual transmission if current automated manual transmission meet for medium-duty markets call to precision specific manufacturing assets as well as intellectual property and people associated with the development, testing and assembly of automated transmission. .

The joint venture has a clear path to profitable growth, and we'll benefit from accelerating transition from a fully manual transmission -- excuse me, to automated transmissions from fully manual transmissions in global markets.

We expect that the next generation of products with advanced performance will gain market share, and a joint venture will leverage Cummins' strong position to grow in international markets where the penetration of automated transmission is currently very low..

The joint venture will also capture aftermarket revenues. We project that the joint venture can more than triple its current sales of approximately $300 million over the next 5 years.

Cummins will consolidate the results of the joint venture within the Components segment, and we expect that the joint venture will be operational in the third quarter of this year, subject to regulatory approvals..

Now let me turn to our first quarter financial results. Revenues for the first quarter of 2017 were $4.6 billion, an increase of 7% compared to the first quarter of 2016 and stronger than we anticipated 3 months ago. EBIT was $566 million or 12.3% compared to $484 million or 11.3% a year ago.

All 4 operating segments increased sales, EBIT dollars and EBIT percent. Our incremental EBIT margin was 28%. .

Engine business revenues increased by 2% in the first quarter due to strong sales to construction customers, especially in China.

EBIT for the quarter -- for the first quarter was 11.3% compared to 10% for the same period in 2016, with the increase due to profitable growth in our off-highway business and strong performance in our on-highway joint ventures in China..

Sales for the Distribution segment increased by 12% with organic sales growth of 6%, driven by stronger demand for engine rebuilds, parts and new engines on on-highway markets. We acquired the last remaining joint venture distributor in North America in the fourth quarter last year, and this acquisition contributed 6% to growth.

First quarter EBIT was 6.1% compared to 5.9% in the first quarter of 2016 and improved as a result of the higher organic sales. .

First quarter revenues for the Component segment increased by 9%, primarily driven by strong growth in sales to Chinese truck OEMs.

EBIT for the first quarter was 13.3% compared to 13.2% in the same quarter a year ago and much improved from the fourth quarter last year when we incurred additional launch cost associated with our new single module aftertreatment system in North America..

We made clear progress in reducing the cost of the single module and improving supply chain performance in the first quarter. And we expect to see further improvement in the second quarter. Our system sales increased by 9% in the first quarter, primarily driven by an increase in new engine and aftermarket sales to mining and oil and gas customers.

EBIT in the first quarter was 6.5% compared to 5.7% a year ago due to the benefit of higher sales and lower operating costs. .

During the quarter, we had disappointing performance on a large power project in the U.K., and excluding the impact of this single project, first quarter incremental EBIT margin was 40%. We expect profitability to improve for the rest of the year and again in 2018, as we get the full benefits from the restructuring of our U.K.

generator set -- assembly operation, which continues to progress on schedule..

Now I will comment on our performance in some of our key markets for the first quarter of 2017, starting with North America, and then also discuss some of our largest international markets..

Our revenues in North America increased 1% in the first quarter with higher sales from the distribution -- distributor acquisition more than offsetting lower Engine and Component sales to the North American heavy- and medium-duty truck markets.

Industry production of North American heavy-duty trucks declined by 20% in the first quarter of 2017 while our sales of heavy-duty engines declined only 12%, as our market share for the quarter improved to 32.7% from 29% a year ago.

Production of medium-duty trucks declined 6% in the first quarter while our engine shipments declined 9% with our market share of 72%, down from 76% a year ago..

Our shipments of engines to pickup truck customers in North America declined by 1%, but we remain on course for a strong year in this segment.

Engine sales for the construction market in North America increased 10% in the first quarter, reflecting increased customer confidence after a challenging couple of years in which the market had to absorb an excess supply of used equipment, resulting from the slowdown in oil and gas markets.

Shipments to high horsepower markets in North America increased by 42% compared to very weak levels last year due to the higher sales to oil and gas and rail customers. Revenues for Power Generation declined by 1% with growth in consumer markets, offset by lower sales to data center customers..

Our international revenues increased by 17% in the first quarter of 2017 compared to a year ago. First quarter revenues in China, including joint ventures, were $1.1 billion, an increase of 49% due to growth in our on-highway and construction businesses.

Industry demand for medium- and heavy-duty trucks in China increased by 73% for the first quarter, driven by a higher pace of infrastructure investment and truck replacement in response to overloading regulations introduced last year..

Our market share for the first quarter was 14%, down from 15% last year. Sales of our ISG heavy-duty engine to Foton grew in line with the market, but growth in Dongfeng's truck sales were not as strong as the industry as a whole.

Last quarter, we discussed actions that we were taking to improve performance of the ISG engine in some applications, and we have made good progress in executing on our plans to support customers who are able to reduce the cost of these actions below our initial expectations..

Shipments of our light-duty engines in China increased by 22%, well ahead of the overall market growth of 12% as Foton continued to increase the proportion of its trucks powered by our joint venture engines, displacing local competitor engines. Our market share during the quarter was 7.6%, up a further 60 basis points from a year ago. .

Demand for construction equipment doubled from a year ago in China in response to stronger infrastructure investment. Our construction engine volumes increased by over 300% as OEMs ramped up their production of excavators.

Revenues for our Power Systems business in China declined by 3% due to continued weakness in Power Generation, marine and mining markets..

First quarter revenues in India, including joint ventures, were $408 million, a 5% increase from the first quarter a year ago. Industry truck production declined 3% compared to a strong quarter a year ago while our market share increased 1% to 39%. Revenues for Power Generation equipment increased by 9%.

We also grew sales in marine and rail markets as a result of growing infrastructure investment..

In Brazil, our revenues increased by 13%, all driven by appreciation of the real as end markets remained very weak. .

Now let me provide an overall outlook for 2017 and then comment on individual regions and end markets. We are now forecasting total company revenues for 2017 to increase 4% to 7%, higher than our prior guidance of flat to down 5% with a modest increase in our projections for a number of regions and end markets.

Industry production for heavy-duty trucks in North America is projected to be 195,000 units, up from our prior forecast of 178,000 units in 2017 but still down 3% from last year and below replacement demand. .

We expect our full year market share to be between 29% and 32%, unchanged from our previous projection. In the medium-duty truck market, we have raised our outlook for the market size to be 112,000 units, up 4% to 2016 and up from our prior guidance. We project our market share to be in the range of 73% to 75%, consistent with our view 3 months ago.

Our engine shipments for pickup trucks in North America are expected to increase 1% for the full year..

In China, we expect full year domestic revenues, including joint ventures, to grow 11% compared to our previous guidance of up 3%. We have raised our outlook for demand for medium- and heavy-duty truck markets to exceed 1 million units, a 7% increase from our previous guidance.

Our forecast anticipates the demand for trucks will slow from first quarter levels due to normal seasonality and a slowing of truck replacement. We expect the light-duty truck market to grow 3% in 2017 compared to our previous guidance of flat. .

Our market share in the medium- and heavy-duty truck market we expect to be 15%, flat with 2016. And in light duty, we expect our share to exceed 8%, up from 7% last year. We currently project 10% to 15% growth in off-highway markets in China compared to our previous guidance of up just 5%, primarily due to higher demand for construction equipment. .

In India, we expect total revenues, including joint ventures, to be flat compared to our previous projection of a 5% decline, due mainly to a stronger rupee. We currently project 5% growth in off-highway markets, offset by an expected 10% to 15% decline in truck demand. .

In Brazil, we expect truck production to be flat in 2017, unchanged from our previous projection with no clear signs of improvement in the near term..

We expect our global high horsepower engine shipments to grow 10% to 15% compared to our previous guidance of no growth in 2017. Demand has picked up in mining and oil and gas markets compared to extremely weak levels last year..

In summary, we expect full year of sales to increase 4% to 7% compared to our prior forecast of flat to down 5%. We are experiencing an increase in some commodity costs, which we are working hard to mitigate.

Rising commodity costs should be supportive of growing demand for capital goods but in the near term, will likely reduce our net material cost savings in the second half of the year compared to our original expectations. .

Our forecast for EBIT is now in the range of 11.75% to 12.5%, above our previous guidance of 11% to 11.5% of sales. During the quarter, we returned $222 million in cash to shareholders in the form of dividends and share repurchases, consistent with our plans to return at least 50% of our operating cash flow this year.

We're off to a solid start, and I look forward to updating you again next quarter..

Now let me turn it over to Pat. .

Thank you, Tom, and good morning, everyone. I will start with a review of the company's first quarter financial results before discussing the performance of each of the 4 operating segments in more detail. I will then provide an update on our outlook for the rest of the year. .

First quarter revenues were $4.6 billion, an increase of 7% from a year ago after 6 consecutive quarters of year-over-year sales declines, the longest period of year-over-year revenue decline since 2002.

The sales in North America, which represented 57% of the first quarter revenues, increased 1% from a year ago primarily due to increased revenue in the Distribution segment, which more than offset lower Engine and Component revenues due to a decline in heavy- and medium-duty truck production compared to the previous year.

International sales improved by 17% from a year ago primarily due to increased sales in China and in Europe, which offset weakness in the Middle East..

Gross margins were 24.6% of sales, unchanged from last year. The benefits from increased volumes were offset by warranty expense, which was a 50 basis point headwind, as we increased accrual rates with new engine introductions and recorded non-favorable change in estimates on older engines. .

Selling, admin and research and development costs of $695 million or 15.1% of sales decreased as a percent of sales by 20 basis points but increased by $39 million from a year ago mainly due to higher compensation expense..

Joint venture income of $108 million increased by $36 million compared to a year ago as a result of strong market demand in China for both on- and off-highway equipment..

Earnings before interest and tax improved to $566 million or 12.3% of sales in the quarter compared to 11.3% a year ago, and this reflects a 28% incremental EBIT margin..

Net earnings for the quarter were $396 million or $2.36 per diluted share compared to $1.87 from a year ago. The effective tax rate for the quarter was 26.1%, in line with our full year guidance of 26%..

Moving on to operating segments. Let me summarize their performance in the quarter, and then I will review the company's revenue and profitability expectations for the full year and conclude with some comments on cash flow for the quarter..

In the Engine segment, revenues were $2 billion in the first quarter, an increase of 2% from last year. International revenues were up 11% primarily due to growth in off-highway markets in China. Revenues in North America declined by 1% due to lower on-highway revenues as a result of the lower production of heavy-duty trucks. .

Segment EBIT in the first quarter was $229 million or 11.3% of sales. This compares to 10% of sales from a year ago.

The margin improvement was driven by higher joint venture income, favorable pricing and material cost savings, which were partially offset by a higher warranty cost and an increase in current product support expense to support recently launched products..

For the Engine segment in 2017, we now expect revenues to be up 2% to 6% compared to our previous guidance of down 3% to 6% with -- due to an improved outlook in most of our markets. Our forecast for EBIT margins is to be in the range of 10.25% to 11.25% of sales compared to 9.5% to 10.5% previously. .

For the Distribution segment, first quarter revenues were $1.6 billion, which increased 12% compared to last year. Organic sales for the quarter increased by 6%, and revenue from the acquisition completed in the fourth quarter of 2016 added an additional 6%. The EBIT margin for the quarter was $100 million or 6.1% of sales compared to 5.9% a year ago.

The improvement to margins from an increase in sales during the quarter was partially offset by higher compensation and benefit costs from the integration of previous acquisitions..

For 2017, Distribution revenue is now projected to increase 4% to 8% compared to our previous guidance of flat to up 4% with the increase driven by improvements in off-highway markets and higher parts sales.

We still expect EBIT margins to be in the range of 6% to 6.75% of sales as higher variable compensation and benefits offset improvements to operating margins..

For the Components segment, revenues were $1.3 billion in the first quarter, a 9% increase from a year ago. International revenues grew 25% primarily due to a 60% increase in sales in China, which more than offset a 2% decrease in North American revenues due to the lower heavy- and medium-duty commercial truck production.

Segment EBIT was $179 million or 13.3% of sales compared to 13.2% of sales a year ago. As mentioned in our previous call, we did incur additional expenses to support the launch of our Single Module aftertreatment system, but we were able to mitigate part of the cost we previously forecast while still meeting the delivery commitments in the quarter..

For 2017, we now expect revenue to be up 6% to 10% compared to our prior guidance of a 2% to 6% decline. The change in guidance reflects stronger-than-anticipated demand in the China truck market and improved outlook for the North American heavy- and medium-duty truck market.

EBIT is projected to be in the range of 12.5% to 13.5% of sales compared to 11% to 12% in the previous forecast. .

In the Power System segment, first quarter revenues were $882 million, an increase of 9% from a year ago. The increase in revenues for the segment was driven primarily by a 28% increase in industrial markets led by mining and oil and gas with growth in new engine and rebuild revenues.

Global Power Generation markets remain weak despite a slow revenue gain in the quarter. EBIT margins were 6.5% of sales in the quarter, up from 5.7% last year due to the increase in industrial engine shipments. .

For 2017, we expect Power Systems segment revenues to be up 1% to 5% versus the previous guidance of flat to down 4% due to increased customer demand from mining and oil and gas engines in addition to higher part sales.

EBIT margins are still expected to be between 7% and 8% of sales with this segment experiencing a more significant increase in commodity costs than we anticipated at the start of the year. .

For the company, we are raising our outlook for revenues to be up 4% to 7% versus our previous guidance of flat to down 5%. The increase is primarily due to improving off-highway market demand, stronger-than-anticipated growth in China and a more resilient North American truck market..

Foreign currency headwinds are expected to reduce revenues by approximately $180 million, slightly lower than the $200 million impact in our previous forecast. The guidance provided today does not include the impacts from the announcement of the Eaton-Cummins joint venture. We will provide a forecast upon regulatory approval of the deal. .

Income from the joint ventures is now expected to be relatively flat from last year. Our strong results in China will offset the impact of the acquisition of the last remaining North American distributor in the fourth quarter of 2016..

We now expect EBIT margins to be between 11.75% and 12.5% for 2017, up from our previous forecast of between 11% and 11.5%. The increase in profitability reflects increased outlook for both the global off-highway markets and the North American truck market. .

Finally, turning to cash flow. Cash generated from operating activities for the first quarter was $379 million, which was a 42% increase from a year ago..

We anticipate operating cash flow in 2017 will be within our long-term guidance range of 10% to 15% of sales. Capital expenditure during the quarter was $81 million, and we still expect investments to be in the range of $500 million to $530 million this year.

And as Tom said, in the first quarter, we returned $222 million to our shareholders through dividend payments and share repurchases. And for 2017, we plan to return at least 50% of operating cash flow to our shareholders, in line with our long-term commitment..

Now let me turn it back over to Mark. .

Okay. Thank you, Pat. And we're now ready to move to the Q&A section of the call. [Operator Instructions]. Thank you. .

[Operator Instructions] And our first question comes from the line of Steven Fisher with UBS. .

Wondering if you can give us a sense of the visibility you have on oil and gas and mining rebuilds for the rest of the year. Clearly a source of strength in the quarter, and obviously an ideal scenario would be that you get these Power and off-highway going at the same time as you have on-highway.

Would that be a scenario that we see later in the year?.

Okay. Steven, it's Rich. Yes, we're off to a good start on the oil and gas rebuilds. In fact, they're off some relatively low numbers that is up 300% right now. And it's pretty broad-based. So we're seeing that kind of across geographies, although primarily North America, but across geographies in North America.

What we also saw in Q1 is some new orders for new frac rigs. And so that is a little less broad-based. We've seen that with 1 or 2 customers, and that's the one kind of yet to be determined is kind of the rate of new versus putting idled equipment back to work. But I think the rebuild piece will continue through the year. .

And that's what you have baked in your 10% to 15% for high-horsepower for the rest of the year?.

Well, that's the engine shipment, Steve, not rebuilds but the overall -- it's embedded in the Power Systems guidance. .

Okay, and just, Tom, last quarter, you stated a lot of dealer inventory in construction in China.

So, I guess, how surprised are you that the China construction was so strong? Was this further building of inventories? Or is it all getting deployed on projects? And then what does that imply for your second half expectations?.

It looks to be not an inventory build. It appears to be that of the inventory we -- is a little higher than what we thought. It seems to be, again, a little more broad-based on the construction side. We were surprised by it. Okay, it was not in our forecast.

But there seems to be a little more sentiment, maybe not data, that says that this could continue on the construction side, in the excavator side in particular. .

Steve, utilization rates are definitely up, and so that's a good sign. That means people are using the equipment there in addition to buying some new. So that's a good sign.

I think it's worth us being cautious just to see where dealer inventory levels are and to understand all that, but we definitely saw sell-through higher and we saw utilization rates higher, both of which are a good sign.

Question is how lasting is it, and how healthy are the dealers and how's the inventory looking? We've still got some more work to do to understand that because frankly, we were surprised by the uptick. .

And our next question comes from the line of Jamie Cook with Crédit Suisse. .

I guess a couple of questions. One relates to your full year guidance. When you guys guided last quarter, you said the first quarter should be the lightest for a number of different reasons. Yet, if we look at your margins for the quarter, they came in at like 12.3%, which is the midpoint of your full year guide. So something doesn't seem right.

Maybe we're conservative, maybe the cost on ISG and the single modular treatment system was lower in the first quarter than we thought. So if you could just sort of walk me through the guidance and whether there's potential for upside.

And then, I guess, my second question, Tom, specifically on the Eaton-Cummins joint venture, just a little more color, I guess, I'm looking at it, you're paying $600 million for potentially $900 million or more of revenues 5 years out, which just seems, I don't know, light or expensive to me.

So are there incremental positives that perhaps the market is underappreciating? And I don't know what... .

Jamie, this is Patrick. Let me start -- Sorry, let me start with... .

Sorry, I don't know what your assumptions are behind that. So sorry, go ahead. .

Sorry, I interrupted you there. Let me take the first question, and then Tom can take your second question that I rudely interrupted. So on the full year guidance, the first quarter includes very strong earnings from China and our China JVs in particular.

And traditionally we tend to see a mix of 60% of China revenues in the first half of the year, 40% in back half of the year. We are a little bit hesitant to assume that the strong demand that we're seeing through the first quarter, what we'll probably expect to see in the second quarter and will continue into the second half of the year.

It's close to [ the announcements ] overloading regulations come into play that's clearly been a factor that'll be driving that. So we are saying second half earnings will drop in China from first half. And that's probably the #1 reason why we are -- maybe our guidance feels a little bit weaker in the second half of the year.

The other fact that is material cost, which drove 80 basis points of margin improvement in the first half of the year as we see rising commodity prices through the year. For the full year, we expect that to be nearly in line with a 50 basis point improvement. So other than that, everything else should continue much as we've seen so far. .

Jamie, thanks for your question on the Eaton JV. So here's the -- and again, in simple terms, we're convinced that leading powertrains will be integrated. That will be industry-wide, that will be whether you have a diesel engine driving at a fuel cell or a battery. We think integrated powertrains will win.

So and that's basically performance quality, all the elements that we think make a difference.

And as you know, as a company, we have continued to invest in the components that we think are essential to driving performance in fuel efficiency and emissions for powertrains because we think that's what made us successful in differentiating in a market of integrateds with a powertrain focus. So we think we have to have an integrative powertrain.

So as we discussed in New York a couple of years ago, that we've been focused on figuring out ways to do that, and we looked at every single option available to us and explored every option in detail.

And we felt like, given the consolidation of the industry, it's already highly consolidated and it's going to consolidate further, both strategically and technically, we needed to figure out a move into powertrains. And our view is that this is by far the most attractive entry point that we could find. And we looked at everything.

And so we feel really good about this.

Good because we think we're getting leading technology that's implementable right now, that we are partnering with a customer -- I mean, a partner that we feel we have a strong -- it's just cultural share -- we share cultural values, we operate successfully in the past, we know each other well so we can ramp up very quickly.

And lastly, we see opportunities for growth outside of the base plan internationally as those markets begin to ramp up into automated transmission. And then we think by providing a better powertrain, our view is we can grow engine share. And of course, that's the big variable in the mix.

The variable that's hard to calculate in here is what happens to our engine share with and without this joint venture, and we are 100% convinced that when you start looking at that, this deal looks not only attractive to Cummins but essential to our strategy. .

Is there any way you could provide a range of how the range of where market share should go? Like just the variability around that? So the joint venture could make more sense. Can 30% go to 40% in heavy-duty? Or is it in China? I'm just trying to think about how to justify the investment. .

I think we will as the joint venture begin to talk about what our growth plans are, et cetera. We need to complete the transaction. As you know, there's a series of regulatory approvals in front of us. And before those are completed, we need to -- we just need to say the main things and then do our legal work.

When that's done, I believe we'll be able to say a lot more what we plan to do together. And I'm 100% convinced that the shareholders of Cummins will believe that this was an essential move and a good move for the company. And I believe the shareholders of Eaton will agree with that. So I feel again very excited about this joint venture.

And again just from a financial point of view, it doesn't take a lot of math to figure out how this could be attractive for Cummins. Again, you basically have to understand that or agree with the basic premise that this is essential to being successful in powertrains. But once you do that, I think it works -- it's pretty straightforward. .

And our next question comes from the line of Ann Duignan with JPMorgan. .

Could you do us a favor and just comment on a little bit more on pricing versus input costs? Could you quantify the impact of higher input costs and when you would expect to be able to offset the higher input costs? And then as a follow-up, I get a lot of questions recently on penetration of electric vehicles and autonomous driving, et cetera, et cetera.

Could you just maybe comment on Cummins perception of the penetration of electric vehicles in particular, particularly in long hauls?.

Ann, this is Mark. So on pricing would be probably closer to net neutral for the year on pricing across our various segments. Where we're having the biggest challenges is, as Pat mentioned, the cost is rising particularly in the Power Systems business, and as you know, we're experiencing still weak global demand in Power Generation.

So it's -- when you've got persistent weak demand, you've got that balancing act to choose, Ann, which you want to press the price lever. So we'll continue to evaluate what options we've got there. And as we've said, well, hopefully that's going to be supportive of growing capital goods demand going forward.

But definitely, less of a net favorable in the second half than the first half. .

And Ann, this is Tom. Thanks for your question on the technology area. So not surprising, I guess, in our strategy work, we've done several years of work now developing both projections and analysis of substitute technologies that might play a role in our end markets.

And we are convinced that electrification, specifically, will substitute in some of our applications over a period of time.

And again, our projections for that depend on large degree, as you guess, on how battery and power electronics costs come down and performance goes up, especially the energy side, how much I can store and then also the cost of fuel and other kinds of environmental-related costs.

But assuming most of our scenarios come up with electrification playing significant role in cities, especially stop-and-go applications, bus, maybe refuse, pickup and delivery trucks, we think it will play a significant role, especially after it makes major substitution in cars since that will drop cost and increase volume.

And we intend, by the way, to compete in that business and win. So we have already launched a electrification business development area in our company, it's people dedicated to not only launching the fully electrified powertrains but are currently selling those powertrains to some customers. So we intend to compete and win.

These are our markets, buses, refuse vehicles, we are the leader in those markets. So we intend to be the leader in those markets when they're electrified. And we already have pilot products running with fully electrified powertrains designed and built by Cummins. So we will compete in those markets, and we believe we'll win.

And so the fully integrated powertrains, as I was mentioning to Jamie, we think are Cummins' future be they diesel-driven, battery-driven, or otherwise. We also think, by the way, fuel cells could potentially play a role in longer haul.

One of the challenges for battery driven longer-haul trucks, which is I think might be obvious in your question, is that you use most of the weight that you would otherwise carry goods for batteries. And so right now, it doesn't look like that's a winner based on the technologies that are available now or in the foreseeable future.

Whereas fuel cells, I think, do a better job of -- still heavier than diesel because the fuel necessary but closer and some of the same advantages as other electrified powertrains. But there's a long way of development to go on fuel cells. They're not nearly as close from a cost performance and quality point of view as batteries are.

So both of those technologies, by the way, I mentioned electrified powertrains and fuel cells, are feasible and could play a role. But both are relatively modest sellers today even in the car side. So it'll be a number of years.

We know from a natural gas front that even when things are very attractive, it takes a long time to substitute in mature markets. And right now, neither of those technologies is attractive.

So there's work to do to make them more attractive, and then there's work to make them work in commercial operations in a sensible way that will work for commercial operators, who, as you know, are very sensitive to capital returns. So I think they'll definitely play a role.

It's going to be some time before the markets are large enough to make a big dent, but we intend to lead in both. And we are putting together the technologies and the customers to be able to do that. .

And our next question comes from the line of Jerry Revich with Goldman Sachs. .

Tom, for your significant joint ventures in the past, you folks have been able to deliver mid-teen margins by leveraging SG&A.

And I'm wondering in the Eaton-Cummins joint venture, would you folks expect a similar profile once that business ramps? Or is there anything structurally different on the joint venture either in pass-through calls or R&D intensity that we should keep in mind as we move towards hopefully the 5-year revenue targets that you laid out?.

Absolutely the same approach, Jerry. As you said, this one because we have a lot of upfront development to get the products to markets. It'll be heavier on R&D expense in early years, but as the revenues ramp up, we expect to be at very similar margins. And again, that's a little bit why we feel confident with this.

It looks like a lot of things we have done before with a partner that we really like working with and know very well. So we have every expectation we'll be able to operate at similar margins as JVs we've operated before. .

And Tom, how back-end loaded is the ramp? Do we have to look for a significant new product introduction cycle so we're -- see a bigger contribution in terms of the growth rate 2020, 2021? Or can we see it kick in potentially sooner?.

There's at least 18 to 24 months of developments dominating the expense ratios in the joint ventures, so that is awhile. I mean, from that point of view, we have a lot of work in front of us to do. Again, a lot of the work has been done on the base transmission, but there's a lot of work to do for integrating with customers.

And I think that's, again, likely to take us 18 to 24 months, and then we'll start to see the ramp up more significantly. So again, we'll be able to say more about that as the joint venture closes and then we can talk a little bit more about who our customers are and all those sorts of things.

But I think just generally speaking, it's first couple of years with more light development, and there'll be sales, of course, but there's going to be pretty heavy development costs. .

Okay. And then, Rich, China Foton Cummins that you folks had warranty issues that you're working through last quarter.

Can you give us an update on how the business performed this quarter? Were there any warranty or product introduction-related costs and the outlook for those costs over the next couple of quarters?.

Yes, thanks, Jerry. Just to remind you, we talked about we had some specific issues in some different regions and different markets, duty cycles we're working through and incurred some cost. And the good news is we've worked through those faster and actually been able to reduce the cost of doing that.

As I talked last quarter, I said we'd be living with those through the first half of the year. And so we're really pleased that we got through it well, took care of customers and generally, by the end of Q1, have any unusual cost behind us. .

And our next question comes from the line of Ross Gilardi of Bank of America. .

I'm just wondering if you could talk about capital allocation from here. I mean, you made an investment that you think is very attractive, but you haven't added the leverage that you initially identified that you'll be willing to consider.

So should we be anticipating other acquisitions from here? Are those leveraged targets you talked about a year, 1.5 years ago still kind of in the game plan? Or is it just the valuations across a lot of the areas of interest have become too expensive, and we should sort of expect Cummins to go back to returning more cash?.

Thanks for the question, Ross. So the answer is we are still pursuing our strategic areas that we talked about 1.5 years ago. I think maybe as you saw in the Eaton joint venture and our powertrain expansion, we think to do a good deal takes more time than to do a lousy deal, or at least that's what we're seeing in the market.

To your point, valuations are pretty high in some places. So in typical fashion, to do the things that we think adds strategic growth and profitable growth to Cummins and good capital returns just turns out are taking us some effort to work through. And that's, I guess, that's probably to be expected. But we intend to continue to pursue those areas.

And yes, the leverage targets we laid out to you are still what we think makes sense for the company. We haven't changed that at all. And we have a number of things that we're pursuing right now that we hope to be able to turn into attractive projects for the company.

But as you suggested by your question, we look through a lot of things that turn out to be less attractive, frankly, from a return point of view and therefore, pass them by. So I think we are active still. I'm confident that we're going to find other good things that will add to the growth and profitability and return profile of the company.

But it's taken some effort and some work to grind through those, and we're still active in them though. .

And then just as a follow-up on that. There were some news reports a couple of months ago about the potential sale of, I believe your filtration business.

And I don't know if you can comment on that, and if you can't, just wondering is there any reason to anticipate that Cummins would ever consider a sizable divestiture if you don't actually have a larger target on the horizon, given the strength of your balance sheet today?.

Yes, thanks. That's a great question, Ross. The filtration business is not for sale as we said then, so I'll just repeat that. The second thing is that we don't -- we would not link our sale of a division with the need to acquire another division, another business.

And the reason is as you remember from the strategy discussion 1.5 years ago, we have enough debt capacity and capital raising ability to acquire a company that we would be interested in, at least the ones that we're considering. We have enough with our existing balance sheet and cash. So we just don't see that as necessary.

We would consider selling parts of Cummins in the same way as we always have, which is if we believe that a division is no longer strategically essential to the company, in the sense that it's not making the whole greater than the sum, which has been kind of the way we thought about our business for a long time.

If it's not doing that, then if we think the shareholders would benefit from the price that we can get versus what we can generate internally, we'd sell it. And we do a review of our big divisions across the company every single year with that exactly in mind.

So we believe that the shareholder -- we owe the shareholders that work to say are -- is the current portfolio of Cummins best owned by Cummins and by the shareholders or should we sell something to realize value and then put it to work in a new and better way.

So we go through our divisions and look at those, and so we would always -- we always do that. And if one of them ended up in that box that said it's not strategic and we think we can get a better valuation, at the very least, we would go test to see if we can get that valuation. And if we could, we would sell it. And if we couldn't, we would not.

So that's something we do as a matter of strategic practice. .

And our next question comes from the line of Nicole DeBlase with Deutsche Bank. .

So my first question is around mining.

So I thought it was good that you guys went through with [ Reynolds ] in oil and gas for rebuilds versus OE, but we've heard from some mining OEMs that OE activity's actually picking up a bit so I'm just curious if you're seeing something similar?.

Yes, Nicole, we are. So it's -- again, like in oil and gas, we're seeing it first on parts, which we started to see, in fact, last year. And that's continued. So our part sales are up double digits in the high-horsepower space, mostly driven by mining and oil and gas. And so from the engine side or the OEM side, we're now projecting up 10% to 20%.

So we are seeing some of that kind of come through and a little less of the idled equipment to deal with that we have in the oil and gas business. So early days, commodity prices are up. And so there's certainly more activity and more discussion, and we're starting to see it in some orders. .

Okay, got it. That's really helpful. And, I guess, my second question is just around China. So last quarter, you guys talked about a competitive pricing environment within China truck.

I'm just curious if that's continued into the first quarter? Or if you've seen that eased?.

I don't think it's impacting our results right now. So that probably there hasn't been significant change at this point in time. .

Yes, most of that was related to market share acquisition by one OEM of the other that launched some new models, that we're trying to acquire. And with the new regulations that are requiring -- on overloading, that are requiring some fleets to actually purchase new trucks, our expectation is that pricing competition will ease.

But frankly, we were even surprised by the size of the growth in the truck market in the first quarter as we were with the excavators. So we have some work to do to understand how well that's going to hold up and how pricing markets are just reflecting back on the first quarter. But right now, we expect the pricing to ease under the circumstances. .

And our next question comes from the line of Stephen Volkmann with Jefferies. .

Just a couple of quick follow-ups, and Tom, I apologize, I'm a little bit slow this morning, but I want to make sure I understand with this Cummins-Eaton joint venture, what does this allow you to do that you weren't doing before because I think you already had a pretty close relationship with them previously, and I'm curious why you felt the need to sort of allocate all this capital to this?.

Yes, it's a great question, Steve. From our point of view, like with most of our Component businesses, we always have the choice of purchasing outside or bringing something inside. And we typically bring it inside if there's -- if 2 conditions are right.

One is that we believe that because of our knowledge of engines and systems, we think we can make a better product for ourselves and for others. And we believe that's true. Now we believe that in integrated powertrains that we can impact the design of the transmission in a positive way by what we bring to the table in terms of engines.

Now we can't, of course, do that through partnerships, it's just not as efficient and not as effective to do. So when we think we can make a big positive impact technically, then we want to be bring them in.

Second thing is that we believe, in this case, that together, we can offer an integrated powertrain with features that are harder to negotiate on when it's commercial negotiation.

We're adding software features, control features, which, frankly, are difficult to price across markets, and we want to make sure that we can do that and win market share in the market and come up with an effective package that includes those features, and which is hard to do so with a commercial arrangement only.

I think -- and on the same front, we want to invest in those technologies and features, but we want to make sure that our partners felt that investing was going to earn a return for them. And it wasn't as clear over the long run that they felt that way.

So to make sure we could add the technology we want, develop the features, price for the features, et cetera, and to make sure that we can offer a better powertrain we felt the need to bring them in.

And again, as I mentioned to Jamie, we spent a long time understanding this, looking at different ways to do it, everything from developing our own solutions to acquisitions and joint ventures in different parts of the world with different partners. And we decided in the end that this was by far the best choice.

And I think from Eaton's point of view, they see it in much the same way. .

Okay, good. That definitely helps. And secondarily, I'm just curious, you talked a little bit about electric drivetrains and fuel cells and so forth, and interesting to hear that you're already sort of testing this stuff.

But I'm wondering if you feel like you have internally that kind of core competency that you need there? Or is this a situation where ultimately, you're going to have to either acquire or a joint venture or something in order to be able to do what you need to do with those alternative type drivetrains?.

Yes, I think it's much like the situation we just spoke about. Our view is that we have the capability to integrate today, just as we have the capability to integrate a powertrain before. But we will likely want to acquire some subsystems of electrified powertrain to make sure that we not only can do it, but we can do it better than everybody else.

So I think it's right what you said that the capabilities that we need to outperform everybody else, we will have to acquire or develop those capabilities in-house for some of the subsystems, things like battery control, packaging, power electronics, especially for the size of the commercial vehicle.

These are things where there are suppliers today in the market, but those technologies will develop the fastest and our ability to have the best ones of those subsystem technologies and integrate them the best will certainly require us to invest more in those areas.

Whether that means acquiring a company or joint venturing again or otherwise hiring and developing our own will remain to be seen. But we are active in all those spaces to figure out exactly that. Again, there's time in front of us, but we -- so we can produce one now and a good one.

But we want be the winner, as I mentioned, which means we're going to have to be expert in some of those subsystem technologies just as we are with diesel, just as we are with natural gas. .

And our next question comes from the line of Robert Wertheimer with Barclays. .

Thanks for the discussion on the sort of forward-thinking strategy. It's very interesting.

Tom, if you were rumored to be spending 2/3 of your time on acquisitions, over the past year or 2, do you anticipate that to be just as intense now? Or does the Eaton JV fill a big enough hole that there's a total little bit less? And secondarily, and you've touched on this, but I mean, do you see more opportunity or more need in acquiring things related to hydrogen or related to electric or related to whatever versus maybe the upside of acquiring pools of revenue where you can operate the business a different way about?.

Thanks, Rob. I thought where you were going with that is since you spent 2/3 of your time, and all you've got is one joint venture to show for it that you weren't sure the time was well spent, but I'll just assume you didn't mean that. So there is no change in my focus in terms of time.

So this joint venture with Eaton is a really important strategic move as I mentioned. We feel very good about it. It only addresses a portion of the strategy areas that we discussed, and so we have a lot more work to go. So I have not slowed down at all. And the answer to your question about which of those is more interesting to us is both.

So the way that, I guess, I think about it is that we have things that we need to do to acquire capabilities in order to stay the course.

In order to be the leading company in what we do now, we have to continue to develop technologies and in some cases, joint venture and acquire technologies in some of these new technology areas and things like that just as we were just talking to Steve and earlier with Jamie.

But we also need to look at opportunities to leverage our capabilities that we have now and potentially expand into new revenue pools. Both of those things are essential for our growth and development as a company.

So our -- we're thinking of growth and capability building, both as part of our strategic effort, and I think the Eaton joint venture demonstrates some of both. And so you'll see us continue to look at both as essential to the company's future. .

And our next question comes from the line of Andy Casey with Wells Fargo Securities. .

Just a couple of follow-ups. The JV stuff has been asked and answered several different ways. But in the near term, it looks like your Power Systems outlook is not anticipating much over the next 3 quarters, and part of that might be this uncertainty that you described with respect to China.

But I'm wondering why not more a follow-through given your comments on oil and gas and mining. .

Okay. Yes, Andy, it's Rich. Well, again, I think what we have seen is in the Power System area, our part sales are going to be up 16% this year. So we're seeing this kind of broad-based activity, which activity is a precursor, hopefully, to new equipment going in. And so, until we see it, I guess we're not putting that in the forecast.

And like I talked in oil and gas, we've even had some indications that this was kind of a onetime bit until some equipment gets rebuilt and refurbished. So we're just paying attention. I think there needs to be some prolonged commodity prices staying higher for a bit longer for the people who are going to make the capital investment.

Until we see that, we'll put it in the forecast. And lastly, you know we're prepared for it. So we've got capacity in place, and one of the things we always try to do is be the best at responding when it comes back. And even if we get surprises, if it comes back quickly, which it does sometimes, we'll be ready for that. .

The other challenges, Andy, at these low levels, even though mining and gas, oil and gas are improving, still 2/3 of the revenue are tied to Power Gen, which at least for now remain fairly muted. So that's what -- that and the commodity cost, these are the factors we're trying to weigh in the outlook for this year. .

Okay. And then another detailed question on warranty, the 50 basis point headwind that you called out in the quarter, and maybe you discussed this, but I missed it.

How much of that was the adjustment, meaning the onetime? And how much is kind of go forward for the rest of the year?.

The onetime adjustment, Andy, was probably close to 2/3 of it, maybe a little bit more. So that's onetime that will not repeat, has been through for the rest of the year. We did anticipate higher rates, higher expense in the first quarter.

As we launch some new engines and we do increase our rates when we launch engines, I think, you'll see warranty come down in the second quarter to more normalized levels, so to speak. .

Okay. Thank you very much, everyone. Adam and I will be available for your call later. Thank you. .

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a wonderful day..