Allison Transmission Holdings Inc Q2 FY2021 Earnings Call

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's Second Quarter 2021 Earnings Conference Call. My name is Maria, and I'll be your conference call operator today. I would now like to turn the conference call over to Mr. Ray Posadas, the company's Managing Director of Investor Relations. Please go ahead, sir.

Thank you, Maria. Good morning, and thank you for joining us for our second quarter 2021 earnings conference call. With me this morning are Dave Graziosi, our Chairman and Chief Executive Officer; and Fred Bohley, our Senior Vice President, Chief Financial Officer and Treasurer.

Thank you, Ray. Good morning, and thank you for joining us. I would like to begin by acknowledging the remarkable progress that has been made in combating an unprecedented global crisis. At this time last year, the pandemic was in the early stages of disrupting populations and economies around the world. Previously inconceivable measures were being taken to protect the health and well-being of our families and our communities. In the midst of the global pandemic, it was difficult to foresee what the next 12 months held in store. Today, much progress has been made, and we are all eager to return to practical and predictable operating conditions. However, meaningful risks with the potential to disrupt the current recovery are very real. With this in mind, we continue to encourage everyone to remain vigilant and, if eligible, get vaccinated.

Thank you, Dave. Following Dave's comments, I will discuss the Q2 2021 performance summary, key income statement line items and cash flow. I will then reaffirm full year 2021 guidance before turning the call back over to Dave. Please turn to Slide 5 of the presentation for the Q2 2021 performance summary. Year-over-year net sales increased 60% to $603 million from the same period in 2020 as recovery in customer demand and the global economy continues to strengthen and despite ongoing industry production constraints due to global supply chain challenges. North America On-Highway and outside North America On-Highway end market led the increase in the year-over-year result with net sales increases of 84% and 63%, respectively. As a result of the continuing recovery in the Global On-Highway customer demand, Service Parts, Support Equipment & Other end markets net sales were up 44% from the same period in 2020, principally driven by higher demand for North America service parts, aluminum die cast components and support equipment.

Thank you, Fred. Earlier this year, during the fourth quarter 2020 earnings conference call in February, we outlined some of our conventional and electrified propulsion initiatives that are driving the recent and planned increases in CapEx as well as R&D spending. Last quarter, we highlighted numerous developments within our fully electric and electric hybrid product portfolio. This quarter, I'd like to highlight several conventional milestones that have recently come to fruition. Despite the challenging state of the global energy markets through most of 2020, Allison remains committed to its Global Off-Highway customers. In fact, when others stepped back, Allison stepped up, reinforcing our commitment and promise to our customers with significant investments and increasingly capable and higher-rated products that will deliver the Allison Brand Promise for years to come.

Our first question is from Rob Wertheimer with Melius Research. Please proceed with your question.

On the powertrain side, it’s still early days, and there are several e-axle and similar propulsion providers available. I'm curious about your competitive positioning when you evaluate platforms, as I know you generally have a strong success rate. Given that it may still be early for a full assessment, how do you perceive the competitive landscape evolving during these initial stages? Thank you.

Rob, good morning. I think I missed the first part of your question.

It was a comment on conventional powertrain. It was good to hear the update there. That's all.

In response to your question about competitive electric vehicle solutions, the EV market is still in its early stages regarding what is actually available and ready for production. There are various providers out there, including traditional powertrain suppliers and new entrants, as the landscape continues to evolve. We believe that several solutions will be necessary to meet the needs of the commercial vehicle market, meaning there isn't a single solution that fits all. Consequently, our strategy is to understand the market's scope and develop multiple solutions to cover the majority of it. We see a limited number of companies capable of offering a comprehensive range of solutions, but many parties, including us, are collaborating on this focus. Our strategy remains centered on maintaining a varied portfolio while working closely with other suppliers and OEMs, and we are committed to adapting as the market continues to change.

Thank you. Regarding the conventional side in China, how extensive are the discussions you're having with different parties about various machine types and machines with higher and lower volume potential? I wonder if your recent announcement indicates more behind-the-scenes efforts. Thank you, I will stop there.

No, it's fine. We continue to work with multiple parties in China, as you know, a very large commercial vehicle market there. They continue to really advance their technology, and their users are demanding more capability, which is certainly consistent with our product offering. And as this recent announcement indicates, we are taking that voice of customer to heart as we always have done in applying our technology across a number of different end markets and applications. And that's an indication of what we would expect to be a number of developments as we continue to work with the Chinese OEMs, and, frankly, the end users. As I said, I think the end users are increasing their demands and requirements ultimately. It's really going to be a combination of working with the OEMs as well as the end users to come up with better solutions.

Thank you.

Our next question is with Ian Zaffino with Oppenheimer. Please proceed with your question.

Hi, great. I know you guys touched upon this a little bit in the prepared comments, but can you dig a little bit deeper and give us an update on sort of the questions du jour supply chain inflation. I know you guys are typically able to pass that through, but maybe touch upon that a little bit, chip shortage. And then I have a follow-up. Thanks.

Let me start by saying good morning, Ian. It's Dave. I'll begin and then pass it over to Fred. Regarding the supply chain, as you may have seen from recent reports from various OEMs and industries, we're observing much of what you've already heard. We initially began discussing supply chain constraints during our third-quarter 2020 call, and I can confidently say that the situation has worsened significantly since then. This has led to extensive efforts across the industry to respond, affecting all levels. Challenges are prevalent in logistics and electronics, among other areas. It’s increasingly difficult to anticipate the availability of supplies for the remainder of this year and planning for 2022. We are closely engaged with both OEM customers and suppliers throughout the tiers, which is demanding considerable time from our team and creating stress throughout the industry. As I noted earlier, some developments that we wouldn’t have imagined before the pandemic are now occurring. I don’t expect a quick resolution. When you consider all these factors, it suggests a strong momentum heading into 2022. However, I believe it will be challenging to defer production at this stage and to integrate new allocations for the remainder of the year. The industry simply doesn’t have enough time, especially when looking beyond North America; if products are not pushed into the market soon, time will run out. This is a critical factor in North America, where we anticipate a limit on deferrals. Similar issues are also beginning to arise in other regions outside North America, amidst ongoing disruptions that have been increasingly apparent over the last few weeks, adding yet another factor to consider. Overall, we see significant challenges ahead leading to inefficiencies in terms of labor and costs, which appear to be affecting everyone in the industry. Now, I'll hand it over to Fred to address your question about costs and inflation.

Sure. Ian, as Dave mentioned, there's certainly inefficiencies due to supply chain constraints, freight, labor, expediting costs, higher overtime rates. The inflationary pressures elevated commodity costs for us, that's primarily steel and aluminum, continue. Based on the timing of our commodity pass-throughs with our customers, we expect the majority of these pass-throughs to occur in early 2022. And looking at the first half, we were at a favorable price of about 110 basis points of price. We've taken other pricing actions throughout the year and really expect year-over-year pricing to be closer on a full year basis to 150 basis points. And this is an increase from what we talked about on the April call of an expectation of 100 basis points. But really prior to the early 2022 commodity pass-throughs to our customers, we do anticipate being slightly price/cost negative.

Okay, good. And then just on another topic. It looks like you're kind of increasing a lot of CapEx. But it seems to be primarily on the conventional side, it sounded like. How are you thinking on the E side, that increase in CapEx? Is there a need maybe to go out and add something additional inorganically into the portfolio? Or sort of where are you thinking on the electrical side? Thanks. Electric side.

Dave here. In response to your question, I understand that our growing investment in R&D is aimed at both traditional and electric vehicle components. With the announcement of our eGen Power and eGen Flex products, we're allocating funds for both R&D and capital expenditures for electric vehicles. As we continue to develop our portfolio and move towards commercialization, we anticipate numerous stages from low-rate to full-rate production over the next several years. We are also making essential foundational investments in our development and production capabilities. The investments we made last year to establish our vehicle test center included testing for both conventional and electric vehicles. Additionally, we have set up testing capabilities in Auburn Hills, Michigan, and are expanding our facilities in the Indianapolis area. Our spending covers a wide range of areas for both electric and conventional vehicles. Regarding inorganic growth, as we have stated before, we are consistently exploring opportunities to enhance our global capabilities. This exploration includes various avenues, including outright acquisitions, and we are continuously assessing potential opportunities to strengthen our capabilities.

Thank you very much.

Our next question is with Jamie Cook from Credit Suisse. Please proceed with your question.

Hi, good morning. I have two questions. First, Fred, can you clarify the incremental costs for 2021 related to supply chain, freight, and material costs? Specifically, which elevated costs might decrease in 2022? My second question pertains to concerns about how electric vehicles may impact Allison's long-term position. Can you help us understand your outlook for top-line growth or margins over the long term? Do you expect sales or margins to be lower compared to historical levels, particularly due to higher R&D costs affecting margins or potential headwinds affecting revenue? Thank you.

Thanks, Jamie. I will speak to the incremental cost that we are seeing in 2021 and R&D, and let Dave talk about top-line revenue in the out period. As we mentioned in our prepared remarks, I mean, there's a significant amount of inefficiencies, expedited freight, enabling suppliers to actually produce product in-house, elevated overtime being run. So I think really broadly across the industry, a significant amount of inefficiencies that should be relatively easy to get out once the supply chain catches up. From an engineering R&D standpoint, we see the same constraints there, with third-party providers having difficulty providing us what we want on the timeline that we want. Originally, the guidance we provided from an engineering R&D standpoint was up 30% year-over-year. Last call, I talked about the spend being about 45% in H1 and then 55% in H2. That 45% to 55% ratio is still there, but really driven by some of the supply chain constraints. At this point, we expect the engineering R&D to be closer to up about 20% versus the original estimate of 30%. I will let Dave comment on out period sales.

Both sales and margins, thanks. On the long-term.

Good morning, Jamie. In terms of our revenue, as we previously discussed, the content associated with our vehicles, particularly regarding e-axles and other solutions, is significantly higher than what is typically seen with conventional products. To address your question about revenue, it ultimately comes down to our market share perspective compared to where we currently stand. However, it's too early for us to make long-term predictions regarding timing or volume. Our focus remains on executing meaningful programs to develop broadly applicable modular solutions. The industry has established high expectations regarding performance, reliability, and total cost of ownership, which we prioritize. We believe that providing value will ultimately be key to succeeding in the market. While there are many competitors, managing power within a vehicle differs significantly from handling just part of that system. Therefore, the revenue will largely depend on volume. Regarding margins, we did not achieve our current margins overnight; that progress took decades. Given the disruptive nature of electric vehicles, we believe it will take years to establish a market position, understand the mature costs, and determine the value of our solutions, which influences our pricing. Unfortunately, there aren't many definitive answers to your questions beyond our commitment to delivering differentiated products that provide appropriate value to users. I should also mention that we are engaged in numerous technology and product initiatives across both electrified and conventional vehicles. We are excited to showcase our latest innovations to the investment community and have planned a virtual technology data showcase for early in the fourth quarter. We will provide more details to the market in the coming weeks.

I appreciate that. Thanks so much.

Our next question is from Ross Gilardi with Bank of America. Please proceed with your question.

Good morning, guys.

Good morning.

You hear me okay?

Yes.

Hey, Dave. Yes, look, several quarters ago, you seem to convey a good degree of confidence that you have an announcement to make with one of the major truck OEMs on e-axle and perhaps just on broader systems integration. You certainly talked about some interesting developments in the Off-Highway space. But we haven't heard much on the On-Highway side, aside from what you've been saying for a number of years. And I’m wondering, should we assume that some type of formalized collaboration with one of the major OEMs is unlikely to be announced over the balance of '21? And then just further to that kind of related to the last question, how do you compete on e-axle with the conventional axle suppliers who seem perfectly content to accept low double-digit EBITDA margins when you yourself are coming from a position where you've got EBITDA margins obviously substantially higher than that?

We expect the remainder of the year to be quite active in terms of announcements. Despite challenging market conditions, our teams are highly engaged and working on multiple initiatives. Regarding competition in the e-axle space, the focus ultimately returns to the value of the solutions we offer. Each player in the market has a unique approach to meeting customer needs. As a preferred powertrain supplier, we believe our capabilities and understanding of factors like total cost of ownership and vehicle integration are significant strengths. While other companies may have the potential to address these issues, it is a considerable challenge to manage all aspects effectively over the lifecycle of commercial vehicles. We feel confident competing with traditional axle suppliers, but our efforts extend beyond that. Our capabilities can be adapted across various propulsion systems. OEMs' experiences with conventional setups illustrate that they value efficiency, standardization, and effective vehicle production—qualities that will remain vital even for electric vehicles. As observed, the initial expectations for electric vehicle specifications and performance seem to be aligning with or even surpassing conventional benchmarks. Meeting these expectations with advanced technology is a formidable task. We are comfortable with our position and welcome competition, as it benefits our customers by providing more options. Given our history and capabilities, we believe we are well-positioned to compete effectively.

Thanks very much.

Our next question is from Jerry Revich with Goldman Sachs. Please proceed with your question.

Good morning, everyone. Dave, could you provide an update on your supply chain discussions and the plans from your suppliers regarding capacity expansion? Do you have an estimate of when we might see an increase in supply for some essential components beyond semiconductors? Also, regarding electric vehicles, we received updates from PACCAR and Volvo about their orders in the last quarter. Could you share a similar update on the number of orders for your systems related to electric vehicles, considering the increase in order trends this quarter? Thank you.

Good morning, Jerry. Regarding the supply chain capacity issues, when do you think this situation will improve? From our perspective, we don't anticipate a near-term resolution. We expect to face a variety of challenges throughout the second half of this year and into 2022. Ideally, we would be wrong and things will improve, but we don't base our business strategy on hope. We expect some of our challenges to definitely improve in the second half. I can't speak to the circumstances of others, but it's important to emphasize that all the necessary components are required to manufacture a vehicle. The original equipment manufacturers have been facing difficulties managing the volume of parts and vehicles involved in the process, which is quite complex. They will continue to encounter challenges, particularly with electronics. Information from semiconductor manufacturers suggests this issue won't dissipate soon. However, regarding our specific challenges, we see some improvement likely in the second half. It's worth noting that during 2018 and 2019, the supply chain was operating at full capacity only to abruptly halt due to the pandemic and restart just as suddenly. This is not a typical industry operation, and it has certainly posed challenges in scaling back up. For that improvement to occur, the necessary components and workforce must be available, which is uncertain as we've experienced extended lead times on machinery. That said, we plan to ensure we can meet market demand and are closely monitoring customer needs more than ever for better forecasting. Concerning your question about electric vehicles, initial feedback suggests that order numbers are relatively low, which is consistent with industry trends. Our timeline for program developments doesn't seem to be moving forward, and there has been a significant amount of effort to handle initial timelines, with some delays becoming evident. This has been our observation as well, with volume orders coming in at the lower end of projected ranges. I have not received any different insights from the parties you mentioned compared to the general market information we are receiving.

Okay. Thank you.

Ladies and gentlemen, we’ve reached the end of the question-and-answer session. And I would like to turn the call back over to Dave Graziosi for closing remarks.

Thank you, Maria. Thank you for your continued interest in Allison and for participating on today’s call. Enjoy the rest of your day.

This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.