Good day, ladies and gentlemen, and welcome to the Q4 2016 Cummins Inc. Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Mark Smith, Vice President, Finance, Operations. Please go ahead.

Thank you, and good morning, everyone, and welcome to our teleconference today to discuss Cummins results for the fourth quarter of 2016. 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. 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 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 in the forward-looking disclosure statement in the slide deck and our filings with the SEC, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and any 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 today's presentation, are available on our website at cummins.com under the heading Investors and Media. Now I'll turn it over to Tom.

Thank you, Mark, for that inspiring introduction. Good morning, everybody. I'll start with a summary of our fourth quarter and full year results and finish with a discussion of our outlook for 2017. Pat will then take you through more details of both our fourth quarter financial performance and our forecast for this year. Our references to EBIT and EBIT percent exclude restructuring and impairment charges taken in the fourth quarter of 2015. Revenues for the fourth quarter of 2016 were $4.5 billion, a decrease of 6% compared to the fourth quarter of 2015. EBIT was $526 million or 11.7% compared to $531 million or 11.1% a year ago. EBIT increased as a percentage of sales as the benefits of our cost-reduction actions and the absence of a loss contingency charge recorded in the fourth quarter of 2015 more than offset the impact of weaker volume. For the full year, Cummins sales were $17.5 billion, down 8% year-over-year. Our EBIT margin was 11.4%, down from 12.5% in 2015. Our decremental EBIT margin for the year was 24%, consistent with our plan even after absorbing $138 million additional accrual for the loss contingency. This solid performance reflects strong execution of our restructuring plan, material cost-reduction programs and quality improvements that helped mitigate the impact of lower volumes in very weak markets. Engine business sales declined by 10% in 2016 due to weaker production of medium- and heavy-duty trucks and softer demand for construction equipment in North America. EBIT was 8.8% compared to 9.9% in 2015 due to the impact of weaker revenues and the increased accrual for the loss contingency in 2016. Sales for our Distribution segment declined by 1% as weaker sales to off-highway markets and the negative impact of a stronger U.S. dollar offset growth from acquisitions. In the…

Thank you, Tom, and good morning, everyone. I will start with a review of the full year 2016 financial results before moving on to our fourth quarter performance. All comparisons in the full year and the fourth quarter of 2015 for the company and for each of the operating segments will exclude the charges for impairment and restructuring actions that we took in the fourth quarter of 2015. Full year revenues for the company were $17.5 billion, a decrease of 8% compared to the prior year. And as Tom just described, declines in commercial truck production in North America and the lowest level of demand for high-horsepower industrial engines and power generation equipment in more than a decade led to the overall revenue decrease. Negative currency movements against the U.S. dollar reduced our sales by approximately 2%. North American revenues declined 12% in 2016 and represented 58% of our total revenues, down from 61% in 2015. International revenues declined by 2% compared to the previous year, mainly due to foreign currency movements. Excluding the impact of the currency movements, international revenues grew almost 3%, with growth in China and in India being offset by weaker demand in Latin America, the Middle East and in Africa. Gross margins were 25.4% of sales and are 50 basis points lower than last year. Material cost reductions and the benefits from restructuring actions taken in the fourth quarter of 2015 offset most of the negative impact from lower volumes and an unfavorable product mix. Selling, admin and research and development costs were up 50 basis points as a percent of sales. They decreased by $145 million in the year due to savings from previous restructuring actions, which were partially offset by added expense through distributor acquisitions. Joint venture income decreased by $14 million compared…

Thank you, Pat, and we're now ready to move to the Q&A section.

[Operator Instructions] Our first question comes from Tim Thein with Citigroup.

First, maybe, Tom, for you. I'm just curious maybe with respect to the kind of the tone of your conversations here and with North American customers and distributors just given what's transpired here over the last, say, 90 days or so. Just curious with respect to their overall set -- tone regarding underlying investment and just kind of a broader question. Just curious if you can address maybe what -- if there's any meaningful change in terms of their attitude.

Thanks, Tim. Let me just say at a high level, as I mentioned in my remarks, our markets are at historically-low levels. We're way below replacement in nearly all of our major markets, and you heard our forecast for the numbers for North American truck. It's really weak, and that's clearly a big headwind going into 2017. And we've been sprinting for quite a few years now to keep costs under control. In fact, improve productivity and cost in all of our facilities and still be able to invest to make sure that we can grow faster than the market when things improve. So we feel like 2017 is one of those years. On the other hand, as you also heard me say, it looks like the move, next move in many of those markets is likely to be up, which I don't think we've been able to say until now. And that -- again, we're planning conservatively. We are, this year, we are assuming that we're going to get very little benefit from any of that. We are planning our costs accordingly, et cetera, but there are some good signs. I think Rich is a little closer to the -- what OEMs are saying in North America. So I'll probably ask Rich to talk a little bit about the truck market specifically and then what other signs that you're seeing, Rich.

Okay. Thanks, Tom. Yes, we're hearing as I talk to fleets, more and more people talking about getting back to replacement levels, where they kind of sat out a years, their mileage was lower, and so that tends to be a common theme, not in every fleet but often. The data -- pre data looks good or at least improving a bit. Dealer inventory looks at a pretty good level. And in fact, there's room to grow the dealer inventory, which we haven't been able to say. And I think the big overhang is just used truck values are still a bit of an issue, but generally, pretty positive on the next move up. We've had 3 months in a row where the production has been less than orders. So the backlog is growing. Again, the future order board is growing for OEMs, and we're already starting to see as those order boards were getting filled out, people are increasing orders. I think maybe in some of the off-highway, I'll do quickly, but oil and gas, we actually are starting, not engine orders, we're seeing a lot of activity in the parts side. The rebuild is coming back in. And I think we mentioned in the comments, the mining business, again, I think the next move will be up there, again, a little bit. It started with parts, which is normal for us, starting to see some improvement there. So generally, I guess, positive. A couple we talked about maybe down would be India truck market, and the marine business does not look like -- that's one we'd say, we don't see that recovery coming yet.

So hopefully that helps, Tim. Sentiment, good; orders, low.

Yes, understood, okay. And just back on Rich's comments on part -- on off-highway parts, maybe a little bit more color on Distribution. It sounds like within that flat to up 4% -- up 3% contribution from the last acquisition. So just maybe a little bit more color in terms of -- I would have thought you would -- the outlook there would have been a little bit more positive. So maybe just some more color on specific drivers within Distribution.

Tim, it's Mark. We are expecting some growth in parts. The one market where we're seeing continued weakness globally is really Power Generation. So that's what's kind of tempering the outlook in the near term.

Well, target range [ph] in sales is generally through the Distribution business, and I think we're looking at that being down again this year, I think 3% to 4%, something like that.

Our next question comes from Jamie Cook with Crédit Suisse.

I guess, 2 questions. One, on the guidance, then the second, more strategic one. If you look at your engine sales in the margins and implied decrementals, the decremental seemed normal. But then if you back out the charges that we had in '16, the implied decrementals, I think, are in the mid to high 30s, which seems -- it seems like it should be better than that. So I'm just wondering if I'm missing something, if you could explain that. And then my second question, Tom, relates more to you. If you look at the past 3 quarters, the repos really falling off, we're not really doing much. So are we -- can you give us an update on sort of where we are? Are we closer to doing a deal? And I guess, as I also think about how you're thinking about the company going forward, I always thought maybe you'd potentially just acquire a business, but I never really thought about whether the parts of the business that don't make sense for Cummins to be in anymore and if so, why would that be? Is it for because you want to do a larger deal for cash because certain businesses aren't generating the proper returns? So I guess those 2, and if you could help [indiscernible]

Jamie, I'll take the first one, and then Tom can take the second one. So on decrementals, let me kind of give you a high-level dredge for the company. It really applies to the Engine segment as much as the company. So if you start from the 11.4% of EBIT that we reported in 2016, we do have headwinds coming through in the form of the lower volume, the unfavorable mix and some of those launch costs that we're talking about with our new products. That's about 70 basis points of a headwind between those 3. We do have higher inflation cost in terms of people costs in 2017, and they're coming through in the form of higher pension expense given the lower discount rates, higher variable compensation in 2016 and then merit increases, so -- and people cost inflation. That's about 120 basis points year-over-year. And then we had some onetime gains in 2016 over about [ph] 30 basis points, and they came through in the form of some of that fair market value gains in Distribution and the gain on sale of the Power Generation asset in the fourth quarter. Offsetting most of that are cost reductions really coming through material costs. We're looking at 80 basis points this year. That's down from 150 basis points last year really given the swing in metal markets. We had 50 basis points of improvement last year in metal markets, 20 basis points negative this year. So net, 80 basis points on cost reduction. The loss contingency that we pointed out is worth 80 basis points. And then pricing, we're thinking some modest pricing improvements that would add around 30 basis points. So when you net all that together, that leaves us somewhere in the midpoint between 11% and 11.5% of sales.

Okay. That's helpful. On the M&A front, any potential for divestitures?

Yes. So let me first just talk about the repurchase of shares. We have continued with our plans on repurchased shares. As you know, we set a goal at the beginning of the year. We drive that program to achieve that goal. We have guidelines that we run with the board about price ranges that we're acquiring in, and we try to make sure that we stay within that, and we run programs through the year. So when you see differences in repurchased shares by quarter, that's more to do with just when we're taking the actions and more the mechanics of it than it is to do with where we've lost interest. We're still hitting our targets for the year of how much we want to repurchase, and so that wouldn't change our strategy at all on that. That's continuing. And then secondly, with regard to the acquisition front, as I mentioned, we are actively working on those strategy areas that we talked about in the Investor Conference, and I'm feeling like we're making good progress. And as I've said before, the problem with describing progress in this publicly is until I have something to announce, I can't announce anything, which is very frustrating to you and other investors I know and frustrating to me, too. But again, all I can do is share my sentiment, I think, at this point, which is I feel like we're making good progress, which means that I think we'll be able to add to our growth platforms at -- within our very tight constraints about making sure they're strategically good and also helps investors with returns over the medium and long run, if not the short run as well. And then last thing, you asked about divestitures. And as we described in…

I'm just going to respond to your first question, Jamie. My calculation shows in the low 20s decrementals on the engine business. We can maybe follow up on that later, but those are pretty normal levels, I think.

Our next question comes from Andrew Casey with Wells Fargo.

A couple of kind of cleanup questions, I guess. The contingency charges, you had some in a few historical quarters, are we clear of those? Or is there some risk those could come back in 2017?

Okay, yes, Andy. Yes, we believe we're clear of those. So the process is we booked what we think was the estimated charge, and there's been no change in that.

Okay, Rich. And then on the Beijing Foton JV, you talked about the costs incurred to improve some productivity and other stuff. How are those going to -- first, could you quantify those in the fourth quarter, because it was pretty sharp falloff? I just want to make sure there wasn't anything else going on. And then how should we expect that JV contribution to kind of play out through 2017? Does it start out weak and then get back to where it should be through the year?

Okay, let me take that, and Mark, if you need to correct any of my numbers, jump in. But yes, so on the ISG, we did take a charge in Q4. And to quantify it, it's roughly $25 million. And so just reminding folks where we are on this product, we remain very excited about it. In fact, our share of Foton now is over 75%. But frankly, we've run into issues in certain duty cycles as we've added more applications in certain regions where either fuel quality or service practices or things we've learned. And so we wish that wouldn't have happened. That hasn't changed our fundamental view. And so I think there will be a charge in Q1 but to a lesser degree, think of kind of half that and all that eliminated as we go into kind of Q2 and Q3 -- on the ISG. And so our strategy hasn't changed. Just like we did on the 2A, 3A, went in China with a brand-new product for the market, compete there and then take the product globally. So we've done that on the 2A and 3A. We're producing 150,000. Quite frankly, we went through a little bit of an issue on introduction as we entered new markets on the 2A and 3A inside China, but we're now selling 50,000 of those outside of China even at Euro 5 and Euro 6 levels part of our strategies. We'll do the same thing on ISG. It hasn't changed our approach.

And I would just add, we've assumed flat markets in heavy, medium and light duty in our guidance. Even in that environment, we'd expect earnings growth in light duty with projected share gains. But as Rich said, improving earnings as the year unfolds.

Okay, Okay, great. And then lastly, a similar question that I think Tim asked with respect to North America. Could you kind of discuss what you're seeing in China at this point? You clearly indicated construction equipment's coming back. Truck had a fairly good second half to the year last year for market basis, yet you're talking about, as you just said, Mark, kind of flat markets for truck in China. What's kind of going on over there?

Yes. So we're projecting flat although I would say our sentiment, even as weeks go by, gets a little bit more positive more than negative, Andy, on this. And there's been -- the new weight restrictions that were put in place are healthy, and so they're being enforced. So I think there are some signs of positiveness, but we just haven't -- we're staying fairly conservative on our forecast just on what the sustainability of that is. There's still some questions. I know there's some ranges. There's people who are more positive than us in the truck market right now. We're going to plan around flat. From a capacity standpoint, of course, we can flex up, and we'll beat it if it's better than.

In the construction market, Andy, it is improving. But just remember, where we're starting from is a far, far cry from where we've seen good markets there before. So yes, we're pleased to see them move up, but it's got a long way to go. And I think it's going to be pretty gradual in its improvement, too. It's just that in the overall market, there's a lot of overhang of equipment still. There's still a lot of dealer inventory. There's a ways for the industry to go. But again, we're happy to see the improvement up.

Yes, there's not a lot of momentum in the high-horsepower side, I would say.

Our next question comes from Jerry Revich with Goldman Sachs.

I'm wondering if you could talk about your updated timing of the 12-liter engine production ramp in U.S. truck. It sounds like the quality issues in China are unrelated based on the description that you laid out, Rich, but maybe you can update us on the time frame. And also, do you have new platform opportunities with Volvo now that they're exiting their 16-liter engine in the U.S.?

Okay, yes. Jerry, yes, so first, they clearly are unrelated -- the quality issues. We're going out taking care of customers, again, kind of related to specific -- either regions or duty cycles in China. Nothing's changed on our schedule. So we'll begin some -- you'll see some trucks here late in the year. It'll be not material in 2017, but we do have agreements with multiple OEMs to begin offering it and remain very excited about it. From the question on heavy-duty on Volvo, we're exclusive on 15-liter with 2 customers with Navistar and PACCAR. And so I am pleased to say we'll now be exclusive on a third, with Volvo, with their announcement of discontinuing the 16-liter.

And Rich, sorry, just the number of platforms that you'll be available on, can you give us just a rough flavor?

I'll say -- at least 2.

Okay, okay. And then coming back on the M&A discussion, you folks have been really focused on driving structurally-higher returns on capital over the course of your time leading the company. And I'm just wondering, are you signaling a longer-term focus on returns on capital, with potential to absorb lower returns near term as you build a sort of meaningful growth platform via acquisitions? Or maybe you could just talk about if you folks are changing the framework in terms of the time frame of which you're targeting the types of return on capital that you folks have generated internally.

I'm definitely not trying to signal or change anything. We've always had a medium to long-term view on return of capital. That's never changed. As you know, we operate a cyclical company and things do go up and do go down even in our own returns on capital. We have long return cycles in our business, as a matter of course, which, of course, is frustrating and difficult to manage, frankly, but it is just the case that we have that. So I'm definitely not trying to signal anything. As we talked about when we talk about potential acquisitions, joint ventures and other partnerships is that we have high return guidelines. We believe that we serve investors well when we retain that attitude that we need to earn good returns on capital with new things we do, just like we do with existing things we do and that taking long ventures into things that don't generate a return would not be good for shareholders, and we're not going to do it. You also know that if we're going to do -- make investments in inorganic that we have to put together a plan that we think works for shareholders or it doesn't make sense. And what that means as far as short term and medium term and long term depends. We'll see when we get there. But just -- I just need you and everyone else to know that we are not backing off anything with regard to our view about generating strong returns for shareholders, and we won't as long as I'm here. I can tell you that.

Our next question comes from Joe O'Dea with Vertical Research.

Specifically on Power Gen and looking for another down year in '17, could you talk about just how depressed that business is. I think we're now looking at 5-plus years of declines -- so what the declines look like from peak. And then beyond the general macro, what signs you're looking at for conditions to start to turn there, whether it's by end markets or geographies, but where we can start to look for some hope in Power Gen given the multiyear declines that we've seen there?

Maybe, I can start just from a high level. I would say that, as you quite rightly said, it's been a long term. We've got 5 years in a row really of very weak markets driven by low investment -- capital investment and especially in developing markets, where we have strong positions, but also nonres capital spending. So those 2 trends have been a strong negative for the business for some time. And with regard to how depressed it is, we're pretty depressed about it. I'll let Mark give you like the -- how much percentage down, but we have certainly have a lot of capacity and -- which is why we took the action we did last year, again, to restructure our capacity and try to reduce costs in a way that allowed us to ramp back up when things get -- turn up again. We still remain highly confident in the business's underlying economics as those economic drivers return. For one thing, we see that the demand for electricity in most of our -- most markets, certainly in developing countries, increasing in terms of the amount of the economy that depends on more reliable power. We also see investments in more reliable power declining as economies decline. So we still believe that in most world economies, they'll be relying on some form of grid support, either through standby generation, other more sophisticated needs for data centers, et cetera, or just in terms of straight backup power in some regions where they have much, much less reliable power. So we believe that those fundamental things are in place, but it has been a long, tough decline, and we've worked actively to try to reduce the impact of those declines, but it's been a tough run. Mark, do you want to comment on all about percentages?

Yes, you're talking about over 30% down from prior -- 5 years ago. And again, that sort of business that isn't depending on one part of the economy or on one particular cycle or down cycle. I think, as Tom said, in some cases, it's not always a lack of demand. Like in Latin America, there's a lot of demand. You've just got, in that case, a lot of customer liquidity issues that are holding back the movement of projects this year. And starting in early last year, we had the Middle East that was doing quite well and then that started to roll up. So it's just been a combination of circumstances. I would say Europe's stable. North America's stable but down a little bit. So it's really the emerging markets, as Tom said, over the last 3 years to 4 years.

And then on the tax rate and looking for, I think, 26% in 2017, should we think about that as being more representative of the tax rate on a go-forward basis? Is there anything unique in 2017? But just you go back a year ago, I think you were looking for something more in kind of high 20s range. Just want to think about this on kind of a longer-term outlook and what the right tax rate is.

Well, the only thing that's different -- There's 2 things are different in 2017 compared to what we said 12 months ago. One, we have a lower share of profits coming out of the U.S., which, as you look out, a higher tax rate today. And secondly, there has been some changes over the last few months in the U.K. and some legislation there that does impact our investment [ph] . So that's the real reason for the delta between the 24.6% that we reported for '16 and the 26% for 2017. The biggest factor is going to be the geographic mix of earnings over the long term.

Our next question comes from David Raso with Evercore ISI.

My question's about the component guidance. It appears to be implying a decremental margin of 55% on a 4% revenue decline. I just want to get more color on why do you think the decrementals would be that poor.

David, this is Rich. I'll take that. Really 2 -- fundamentally, 2 things. One is, volumes down again in North America is what we're projecting. And then two is, as was mentioned, some startup costs associated with our new Single Module aftertreatment in our aftertreatment business. And so just to remind you, we're making a really big change there, and it's not a small change in our aftertreatment. One, it's at half the size, half the weight, taking the maintenance intervals up by a factor of 2. So it's a brand-new product, and we've had some startup kind of expedited costs and all that we had in Q4. And I mentioned those will continue into Q1. So those are the 2 things that are happen -- that are really dragging that down for 2017.

How much are those investments? Because even if I hit you with a 30% decremental, it adds almost $0.20 to your guidance for the year. So I'm just trying to think about how big those costs are just so I can get a better feel for how reasonable the guidance is.

Well, the aftertreatment piece of the startup, we're talking in the $20 million to $30 million range for the year, and then you know what our incremental margins are, and you've seen before as volumes come back. So if volumes come back to more normal levels, when and if that happens, then you'll see that turnaround.

Yes. The other thing I would throw in there, David, too, if you go back to my answer to Jamie Cook earlier on, we are seeing some inflationary metal markets, which is impacting the segment, and we are seeing some impact on compensation inflation, too. So there's 2 or 3 headwinds that's impacting us in 2017. We'll figure our way through then get back to normal markets.

But you should see improvement in the second half versus the first half.

Yes, and not to nickel and dime you. Even with that cost on the startup, you're still implying decrementals over 40? I'm just trying to make sure -- I mean, is the inflation problems particular to components more than other segments?

No, it's not. So again, just thinking through your view of our guidance. Again, as I've said kind of as an overview, we're taking a pretty conservative view of bad markets. And so I think the biggest opportunity we have in the Components business is that North American markets strengthen more and faster than what we have in our guidance, and you probably have a reasonable view about your opinion on that. So that would be one thing that you could take a look at if you wanted to. But again, our view is that we're going to continue to manage conservatively. We're going to continue to find ways to take costs out. So again, as you know, we are not satisfied with decremental margins of that level. We're not pleased with that. We are working hard to figure out how to make that less of an impact, but we're giving you the forecast based on what we think we understand how to do right now. We'll continue to work on decremental margins in that business. That's a very -- it's a very profitable and good business for Cummins, and we're going to continue to make it so.

And last quick question on the M&A conversation. How do you think about strategically off-highway versus on-highway, just all the secular issues that we're all aware of on-highway as well as some of the benefits you've built up with your Distribution acquisitions? Just how should we think about those 2 markets and how they impact your strategy?

Yes. So on-highway, as you said, it's a bigger volume. It's -- so it tends to drive a lot of the technology, and there's -- there is -- of course, we have a very strong position on on-highway, and the fact that we lead in emissions and other technologies has helped us build a strong position there. On the other hand, as you've quite rightly said, in off-highway, there is less vertical integration, and also our Distribution is well positioned globally to serve a bunch of markets that other people can't serve. So both have important roles in our strategy. And frankly, we think one of the advantages of Cummins is we're able to put the 2 together in a way that drives synergies that most others can't. So as I think about it strategically and I think about things we might do more of, I'm thinking about both those areas and how we can continue to use the synergy between the 2 to drive more returns to shareholders than others can.

I think we're at the top of the hour. Thanks, everyone, for your questions, and Adam and I will be available for follow-up later.

Ladies and gentlemen, thank you for participating in today's conference. You may all disconnect. Everyone, have a great day.