Allison Transmission Holdings Inc Q3 FY2020 Earnings Call

Good evening, ladies and gentlemen, and thank you for standing by. Welcome to Allison Transmission's Third Quarter 2020 Earnings Call. My name is Lisa, and I will be your conference operator today. At this time, all participants are in a listen-only mode. After the prepared remarks, the management team of Allison Transmission will conduct a question-and-answer session. And I would now like to turn the call over to Mr. Ray Posadas, the company's Managing Director of Investor Relations. Please go ahead, sir.

Thank you, Lisa. Good evening, and thank you for joining us for our third quarter 2020 earnings conference call. With me this evening are Dave Graziosi, our President and Chief Executive Officer; and Frederick Bohley, our Senior Vice President, Chief Financial Officer and Treasurer. As a reminder, this conference call webcast and this evening's presentation are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through November 5. As noted on slide two of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These forward-looking statements are subject to known and unknown risks, including those set forth in our third quarter 2020 earnings press release, our annual report on Form 10-K for the year ended December 31, 2019, and our quarterly reports on Form 10-Q for the quarters ended March 31, 2020, and June 30, 2020; uncertainties related to the COVID-19 pandemic and related responses by governments, customers, and suppliers, and other factors as well as general economic conditions. Should one or more of these risks or uncertainties materialize or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those that we express today. In addition, as noted on slide three of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached to an appendix to the presentation and to our third quarter 2020 earnings press release. Today's call is set to end at 5:45 p.m. Eastern Time. In order to maximize participation opportunities on the call, we'll take one question from each analyst. Please turn to slide four of the presentation for the call agenda. During today's call, Dave Graziosi will provide you with a brief operational update, Fred Bohley will then review our third quarter financial performance, provide an update on Allison's liquidity, and review our full year 2020 guidance. Finally, Dave will conclude the prepared remarks prior to commencing the Q&A. Now I'll turn the call over to Dave Graziosi.

Thank you, Ray. Good evening, and thank you for joining us. We're pleased to report that Allison's third quarter results improved significantly following the severe disruptions experienced in the second quarter, as customer demand and the global economy continue to recover. Despite the positive momentum, the uncertainty associated with the global pandemic remains. Going forward, we will continue to prioritize the health and well-being of Allison's extended family and align our operations, programs, and spending with current end market conditions while mitigating the risks that we anticipate will last for the foreseeable future and maintaining the flexibility to respond quickly and appropriately. I'd also like to take this opportunity to thank all of Allison's employees, customers, and suppliers once again for their commitment, dedication, and resilience that has supported the uninterrupted delivery of our products throughout the year. Year-to-date, Allison continues to demonstrate solid performance as well as the consistent generation of earnings and positive cash flow. Sequential net sales increased over 40% as the severe economic weakness and customer shutdowns experienced during the second quarter abated, and it rebounded relevant business activity and sentiment generated improved demand for both medium-duty and Class eight straight locational trucks. Furthermore, in the third quarter, we settled $16 million in share repurchases and paid a dividend of $0.17 per share. Due to our long-standing commitment to prudent balance sheet management, ample liquidity, and profitable operations, Allison remains well-capitalized and positioned to navigate the challenges presented by the evolving and uncertain environment, benefit from a recovery in demand, and capitalize on future growth opportunities. As we look beyond 2020, we will continue our prudent and disciplined pursuit of our strategic priorities and commitment to improving the way the world works indoors. Thank you. And now I'll turn the call over to Fred.

Thank you, Dave. Following Dave's comments, I'll discuss the Q3 2020 performance summary, key income statement line items, and cash flow. I'll then review Allison's liquidity and reintroduce full year 2020 guidance before turning the call back over to Dave. Please turn to slide five of the presentation for the Q3 2020 performance summary. Net sales decreased 20% to $532 million compared to the same period in 2019. The decrease in net sales was principally driven by the ongoing effects of the pandemic on the global economy, resulting in lower demand across all of our end markets, except for the defense end market. Gross margin for the quarter was 47.7%, a decrease of 430 basis points compared to 52% for the same period in 2019. The decrease was principally driven by lower net sales, partially offset by price increases on certain products and lower compensation expense. Net income for the quarter was $77 million compared to $140 million for the same period in 2019. The decrease was principally driven by lower net sales and higher sales, general, and administrative expenses due to unfavorable product warranty adjustments, partially offset by lower manufacturing expense, price increases on certain products, and the intra-year timing of product initiative spending. During the third quarter, a $23 million product warranty adjustment was recorded to address the transmission performance issue associated with quality on a specific population of products. We stand behind the Allison brand promise of quality, reliability, and durability for every product that carries the Allison name. This unwavering commitment is supported by investments in our people, equipment, and processes, which have enabled an average product warranty expense at the percent of net sales of just 1% from 2013 through 2019. Adjusted EBITDA for the quarter was $174 million or 32.7% of net sales compared to $269 million or 40.2% of net sales for the same period in 2019. The decrease is potentially driven by lower gross profit and unfavorable product warranty adjustments, partially offset by lower commercial activity spending and the inter-year timing of product initiative spending. Adjusted EBITDA without the product warranty adjustment recorded in the third quarter was $197 million or 37% of net sales. A detailed overview of our net sales by end market can be found on Slide 6 of the presentation. Please turn to Slide 7 of the presentation for the Q3 2020 financial performance summary. Selling, general, and administrative expenses increased $8 million or 9% from the same period in 2019, principally driven by unfavorable product warranty adjustments, partially offset by lower intangible amortization expense, lower commercial activity spending, and lower incentive compensation expense. Engineering, research, and development expenses decreased $6 million from the same period in 2019, principally driven by the intra-year timing of product initiatives spending. Please turn to Slide 8 of the presentation for the Q3 2020 cash flow performance summary. Adjusted free cash flow for the quarter was $136 million compared to $165 million for the same period in 2019. The decrease was principally driven by lower gross profit, partially offset by reductions in cash income taxes, capital expenditures, operating working capital requirements, commercial activity spending, and the intra-year timing of product initiative spending. Please turn to Slide 9 of the presentation for the Q3 2020 liquidity update. We ended the quarter with a net leverage ratio of 3 times, $251 million of cash, and $595 million of available revolving credit facility commitments. We continue to maintain a flexible, long-dated, and covenant-light debt structure, with the earliest maturity due in September 2024. During the third quarter, we settled $16 million in share repurchases and paid a dividend of $0.17 per share. We ended the quarter with approximately $856 million of authorized share repurchase capacity. As we continue to navigate the unprecedented challenges of the year, our unwavering commitment and well-defined approach to capital structure and prudent balance sheet management remains intact. As a result, Allison continues to operate from a position of strength and maintains the optionality to pursue growth and capitalize on opportunities that are consistent with our strategic priorities. Please turn to Slide 10 of the presentation for the 2020 guidance update. Given the improvements in customer outlook and supply chain readiness in the United States and other major markets in which we operate, we are reintroducing full year 2020 guidance. Our updated full year 2020 guidance includes net sales expected to be in the range of $2.025 billion to $2.075 billion; net income expected to be in the range of $285 million to $315 million; adjusted EBITDA expected to be in the range of $690 million to $730 million; net cash provided by operating activity is expected to be in the range of $490 million to $520 million; adjusted free cash flow expected to be in the range of $385 million to $425 million; and capital expenditures expected to be in the range of $107 million to $117 million. Allison's full year 2020 net sales guidance reflects lower demand across all end markets, except the defense end market as a result of the pandemic, partially offset by price increases on certain products. As Dave mentioned, we remain focused on aligning operations, programs, and spending with current end market conditions, and we will continue to make adjustments as conditions warrant. Finally, we remain steadfast in our commitment to future growth, and we will continue to fund key product development initiatives that will drive the expansion of our business and further secure our leadership position in the end markets that we serve. Thank you, and I'll now turn the call back over to Dave.

Thank you, Fred. Earlier this month, we announced the launch of Power, Allison's new line of fully integrated zero-emission electric axles for medium and heavy-duty commercial trucks. We also announced the 100 D, Allison's first electric axle variant within this product line. The Power 100 D is one of the most powerful and fully integrated electric axle systems in the world. In fact, several major global OEMs have chosen to integrate Allison's Power Electric axles into their electric truck development and validation programs, most recently HINO trucks and Hexagon Purus showcased a Power 100 D equipped HINO XL seven truck during HINO's October 5, 2020 announcement of their project B, their zero-emission vehicle development program, which will be manufactured in Allison's recently completed 110,000 square foot electric axle development and manufacturing facility in Auburn Hills, Michigan. The product features two electric motors capable of generating 400 kilowatts of continuous power and a peak combined power of 550 kilowatts. It also integrates two-speed transmissions into the central housing, facilitating high starting gradability and top speed, increased efficiency, and an optional differential lock. Allison's fully integrated Power line of electric axles eliminates many of the inefficiencies of competitive e-axle solutions. The efficiency advantage translates to increased range capability or a reduction in battery pack size, optimizing the economic value of the Power electric axle delivery. While full electric propulsion technology remains in the early stages of development, the opportunity for Allison is meaningful. We anticipate that content per vehicle for fully integrated electric axle solutions could range from three to ten times that of a conventional transmission for a Class 6 or 7 truck. The broad range accounts for the optionality customers will have regarding the level of integration and componentry available. Our engineers have been developing electric solutions for commercial and military vehicles for decades, and we are well-positioned to continue delivering the Allison promise of quality, durability, and reliability with our new line of fully integrated electric propulsion solutions. Our product family is the second offering under the recently announced Allison of fully electric and electric hybrid propulsion solutions. Earlier in the third quarter, we announced the launch of Allison's new zero-emission capable electric hybrid system, providing bus fleets with the full electric engine of propulsion for up to 10 miles and full electric accessory power operation capability ideal for zero-emission zones and depot operations without the range limitations or infrastructure requirements of full electric solutions. Recently, Indigo, the Indianapolis Public Transportation Corporation, announced that it will be a lead fleet partner for Allison's revolutionary new electric hybrid propulsion product, demonstrating its commitment to reducing its dependence on fossil fuels, enhancing quality of life in their community, and protecting the environment while minimizing the total cost of ownership. As interest in electrification continues to gain momentum, many fleets remain reluctant to go all-in on full electric at this early stage. Critical feedback from our customers inspired Allison to develop the Egen Flex with enhanced capabilities for coach and transit buses, effectively serving as a bridge solution between conventional fuel and full electric solutions. The Egen Flex will enable transit fleets to evaluate full electric capabilities and their needs while still having the availability of a diesel range extender, whether needed for longer or flexible routes, unplanned congestion, or an inability to recharge due to power grid challenges. No additional capital infrastructure investment is required to utilize its full electric operation capability. With the new Egen Power line of electric axles and a new Egen Flex electric hybrid system, Allison is building on a foundation of safe, sustainable, and efficient propulsion solutions created throughout our 105-year history. Our unwavering commitment to innovation and product development, combined with our financial strength, robust cash flow generation, and strong margin profile positions Allison to lead the way into the future of commercial vehicle electric propulsion. The Egen portfolio is the latest example from a broad and diverse range of product development initiatives we are undertaking at Allison. As we've highlighted throughout the year, the resiliency of Allison's business is inherent in its strong market position in diverse end markets. While the pandemic continues to impact its commercial demand, the essential business of the United States National Defense continues unabated, and Allison remains committed to supporting the United States Military on current and future programs. The U.S. Army is currently evaluating two prototypes for the new armored light tank, the mobile protected firepower program to support units with additional firepower. Allison's 30 and 40 MX cross drive transmissions designed for medium tracked combat vehicles weighing between 25 and 40 tons have been selected by both manufacturers competing for the Army MPF program. Testing of the prototype MPF platform begins this winter with a final selection planned for the summer of 2022. Volumes for the MPF program are anticipated to reach more than 500 vehicles over 10 years. In addition to the domestic opportunities for Allison's 340 MX cross drive transmission, we are collaborating with U.S. allies to meet their transmission requirements for medium weight armored vehicles. We also continue to work with our defense end market partners in the pursuit of additional wheeled and tracked opportunities around the world. Allison has always been at the forefront of innovation, and notwithstanding the considerable uncertainty that lingers in global markets, we remain committed to meeting the current and future needs of our customers across all the end markets we serve. We will continue to invest prudently and appropriately to drive growth, expand our market leadership, and further position Allison as a preferred and long-term partner. We look forward to providing you with additional product and collaboration updates in the coming months. This concludes our prepared remarks. Lisa, please open the call for questions.

We'll take our first question from Jamie Cook with Credit Suisse.

A nice quarter. Dave, I just, understanding it's still early, but you generally have a good read on the market. Your initial views without quantifying on 2021 based on somewhat of what the industry guys are saying, which markets have the best opportunity to grow? And in that vein, should we expect above-average incremental margins from Allison typical of history, given that you don't have some of the temporary cost headwinds coming back in 2021, like some of your peers?

Good morning, Jamie. I appreciate those questions. So first, thank you for the recognition on the quarterly results. As I said in the prepared remarks, I think the team here with all our partners continues to work very diligently to stay safe and work appropriately amid what I think are very challenging conditions. Having said that, I think your questions on 2021 are valid. As you know, at this point in the year, typically, we are in a strong position to provide guidance. I would certainly offer a few thoughts in that regard. Generally speaking, at least the tone from the market reads that we have, if you think about our largest end market being North America on-highway, I would say generally speaking, the American participants and third-party forecasters appear cautiously optimistic that demand conditions will further improve, subject to numerous caveats relative to the pandemic. Why I say that, as you all know, she or he who defines controls, and this is one of those areas where as we start thinking about 2021 and the number of changes we've already made in our business, to your point on cost, that's one that's a near-term focus for us because we are certainly making assumptions as everybody else is. I would generally tell you to the feedback that I just provided. Certainly, there's an expectation that there are better market conditions in '21. I think the challenging part, though, is how you start the year because as we currently sit, we've provided guidance for the balance of 2020. We've also made a number of assumptions relative to the pandemic. I think recent developments here over the last few weeks, as you're well aware, are somewhat concerning from the standpoint of a potential return of restrictions, and what does that really mean as a setup to 2021. So I think that as we currently sit today with general expectations, we certainly expect better market conditions, almost across the board and all of our end markets for next year. But again, I think it's far too early, as it normally is at this time of the year, but I think with the pandemic, to provide a very clean read. I would also offer the comments that were made in the prepared remarks, we invest through the cycle. As you know, we are continuing to drive despite what I would describe as challenging conditions. The initiatives that we set out that are market-driven are continuing to execute along those lines. Back to your point on incrementals, certainly with better market conditions next year, we would expect better incrementals. I would also offer as part of that, the cost structure changes that we made earlier this year, we continue to feel very good about. I think you would expect, as we've outperformed our expectations, some of those costs have crept back in, but they're really more variable. We're certainly happy to handle the incremental margins tied to those. So with that, we'll look forward to the first call in the first quarter to provide a more comprehensive answer to your question.

We'll take our next question from Ian Zaffino with Oppenheimer.

Hi, guys. Thank you very much. Thanks for a little color on the EV side. I think you mentioned three to ten times more content than you typically would expect in a traditional vehicle. How are you arriving at that? What needs to be included at the low end? What needs to be increased at the high end? And I know we're super far away from any kind of implementation of this, but as you talk to your customers, what are you saying? And where should we maybe expect an average between three and ten times?

Yes, I appreciate the question there. So the three to ten times broad range, as you note, is due to the fact that we are assuming that there are a number of customers and end users, some may require a complete solution, so to speak, that being electronics, batteries, and the propulsion solution itself. But overall, that's a complete system. You can imagine the cost of batteries and the electronics in addition to whatever propulsion device there is. So our range incorporates or provides a range, which assumes just, for instance, an electric axle, right, all the way up to a full system potentially. So that's really the range. But if you think about on average with a medium class vehicle by North American standards, that range should size pretty quickly in terms of what our basic transmission sells for with support equipment as a source of that multiplier. But it's really not, I think, our reach is unreasonable at this point. I would also offer the reason why we're providing a range is, as we said in the prepared remarks, we are assuming there will be a range of customer desires in terms of what they look for from either a component or a solution set. And we certainly believe that end users will look to pick and choose, frankly, the best overall solution for them. I think that will evolve over time from what you're seeing in the early days here to more mature solutions and technology. But as we sit today, there's a very high level of variability around what's desired, but you don't have a mature long-term view. From our perspective at this point in terms of what every end user, the vehicle manufacturers are going to be looking for. I think every one of them has a slightly different playbook, and there is a long period of time here to play that out.

We'll take our next question from Rob Wertheimer with Melius Research.

And Dave, thanks for the overview on the Egen side. I did actually want to ask one more question on that, if I could. And just if you could talk about, obviously, you have long experience in hybrid drivetrains and lots of OEM experience too. But what do you see as your natural sort of hook into the axle business? Is it common calculation, etc.? Is it common manufacturing? Or is it simply knowledge of the end customer? I'm just thinking about your core competitive advantage as it develops over the next couple of years.

I appreciate that question. So if you think about Allison, we are a propulsion solutions provider. We don't consider ultimately the energy source to differentiate us, right? At the end of the day, we provide propulsion solutions. As you think about what we do, that's a series of tests. And it starts with the last item you mentioned in terms of knowledge of locational duty cycles and applications. There is a fairly high level of variability. We talked many times about the number of calibrations that our team has developed over decades to run a very wide range of vehicles. They all, at some level, require different controls for different behaviors that end users want. We believe our history speaks for itself in terms of the reliability and durability of the solutions we put out there and understanding that demanding level of duty cycles that are required. We are very focused on providing that solution, if you will. I would offer to you, as we think about electrification, to your point about what differentiates us, we start out with the objective of providing a conventional experience with an electrified solution. Right? So you think about today, they're extremely high, highly reliable systems overall. End users typically know at a very finite level what the experience is going to be, what the total cost of ownership is, etc. You really can't say that about electrification today; it's evolving. But our intention, as we've worked in this space, and frankly, our history with even hybrid electric solutions, is that you learn a lot. That creates a very high expectation and a bar to meet. And we think our controls experience, locational knowledge, and application across the globe, as well as our mechanical understanding, as we think about, we mentioned the efficiency of the electric axle solution that we're developing and offering, ultimately, is a more efficient solution than others. There's a reason for that because it's ultimately going to impact cost. So you want to deliver something that's highly reliable and mirrors a conventional experience for the end user. That touches upon many of the strengths that we have as a team and as a business. We're looking forward to continuing to apply those to the electrification space and a number of different solutions, whether that's full electric or the continued extension and evolution of hybrid.

We'll take the next question from Luke Junk with Baird.

Just wondering relative to the discussion around your three to ten times content opportunity for electrification. Can you maybe talk about the payback that you see inherent in that for the end customer? Maybe relative to what you target for traditional transmission. Do you think that we're ultimately getting to something that is going to be more commercially viable at this point?

We target on the conventional side, a two to three year payback on a premium product. And that's what our end users demand. In the electrification systems that we are developing, those expectations are the same. As Dave mentioned earlier, their expectations around payback are similar; they're going to get the reliability and durability that they get in the conventional space. So I think initially, any new product needs to prove itself; there's an element of skepticism, and it needs to prove it can go the lifecycle. Where we sit today, you still need significant improvement in battery cost and capability to get anywhere close to the payback that the end users expect. So there are going to be locations that are more prone to adopting without an appropriate payback, locations such as transit properties that have other funding sources. But again, there's challenges there with battery operation to meet the duty cycle. And that's why we're also seeing the electric hybrid being a very good solution there. So the answer is, our expectations on payback are the same. Our customers have those same expectations. Realistically, battery capability needs to improve, and you also have to factor in the infrastructure investment required to achieve the appropriate payback.

And we'll take our next question from Seth Weber with RBC Capital Markets.

This is Brendan on for Seth. Your parts service business was a little bit better than we had expected. I was wondering if there's anything worth calling out there? Just any additional color there would be appreciated.

To your point regarding what you expected, I'd call out a few things. The third quarter featured a full quarter of additional sales from Walker Die Cast; that acquisition occurred in September of last year. So that's one aspect. When you look at it over a year-over-year basis, that's included, and we continue to be pleased with that acquisition and the progress of our team there, as well as responding to the market conditions and the increased interest that is apparently, more broadly known, around localization. The balance of it, in terms of on-highway, I would describe as stabilizing as you know, pretty simple with Q2. But as we think about the market here, it's certainly stabilizing. There is some seasonality in Q4, although I think some of that may be mitigated a bit. I would describe the space as stabilizing globally relative to on-highway. Clearly, off-highway is much softer as you know, with hydraulic frac in North America being in largely a rebuild maintenance mode at this point and working through end users, equipment owners cannibalizing equipment, and reducing fleet sizes. I would expect that overall concept to carry itself as a focus over at least the medium term. The balance of the portfolio in support equipment really follows volume. Volume is obviously up sequentially, and when we look at it year-over-year, it's down. But I think those are the broader attributes that I would call out.

And that does conclude the question-and-answer session. I would like to turn the call back over to Dave Graziosi for any additional or closing remarks.

Thank you, Lisa. Thank you again for your continued interest in Allison and for participating in this evening's call. On behalf of the entire Allison family, we wish all of you, your families, and colleagues good health and safety. Enjoy the rest of your evening.

And that does conclude today's presentation. Thank you for your participation. You may now disconnect.