Allison Transmission Holdings Inc Q2 FY2022 Earnings Call

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's Second Quarter 2022 Earnings Conference Call. My name is Kyle, and I will be your conference call operator today. After the prepared remarks, the management team from Allison Transmission will conduct a question-and-answer session, and conference call participants will be given instructions at that time. As a reminder, this conference call is being recorded. 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, Kyle. Good afternoon, and thank you for joining us for our second quarter 2022 earnings conference call. With me this afternoon are Dave Graziosi, our Chairman and Chief Executive Officer; and Fred Bohley, our Senior Vice President, Chief Financial Officer and Treasurer. As a reminder, this conference call webcast and this afternoon's presentation are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through August 10. As noted on Slide 2 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 second quarter 2022 earnings press release, our annual report on Form 10-K for the year ended December 31, 2021, and our quarterly report on Form 10-Q for the quarter ended March 30, 2022, uncertainties related to the war in Ukraine, 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 3 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 as an Appendix to the presentation and to our second quarter 2022 earnings press release. Today's call is set to end at 5:40 p.m. Eastern Time. To maximize participation opportunities on the call, we'll take one question from each analyst. Please turn to Slide 4 of the presentation for the call agenda. During today's call, Dave Graziosi will review highlights from our second quarter 2022 results and provide a brief operational update. Fred Bohley will then review our quarter financial performance and the full year 2022 guidance prior to commencing the Q&A. Now I'll turn the call over to Dave Graziosi.

Thank you, Ray. Good afternoon, and thank you for joining us. We are pleased to report solid performance for the second quarter of 2022 and a 25% increase in diluted EPS. Following the strong start to the year, second quarter results demonstrate the resiliency of customer demand and continued year-over-year growth. In spite of the challenging environment, the Allison team continues to deliver balanced execution while driving multiyear growth initiatives across all of our end markets. Net sales for the quarter were $664 million. Notably, net sales growth of 10% was once again surpassed by diluted EPS growth of 25%, and Allison's disciplined and well-defined approach to capital allocation continues to support per share returns in excess of net sales and net income growth. As a result of the ongoing strength in Allison's Global On-Highway and Off-Highway end markets, we are pleased to reaffirm the full year guidance midpoint while narrowing the guidance ranges provided to the market on February 16. Despite concerns of a slowdown in economic activity, customer demand remains robust, with industry production limited primarily by persistent supply chain constraints. We anticipate the current complex and uncertain operating environment will continue for the foreseeable future. Though supply chains have not uniformly improved, end-user demand remains strong, and the Allison team continues to take actions that address and mitigate production challenges. In prior quarters, we have discussed several initiatives that support Allison's long-term growth objectives. Among them is Allison's award-winning 3414 Regional Haul Series fully automatic transmission for the North America heavy-duty regional haul and day cab tractor market. Currently released with Navistar, Daimler Trucks North America, and Volvo Trucks North America, the 3414 RHS expands our addressable market, enables the pursuit of market share growth, and represents an incremental revenue opportunity of $100 million annually. Following the initial launch during the summer of 2020, the Allison 3414 RHS has surpassed expectations, realizing meaningful success in a short amount of time. The 3414 RHS is now operating in 3 of the top 5 largest private fleets in North America, which collectively operate approximately 25,000 regional haul tractors. Another growth opportunity is Allison's next-generation hydraulic fracturing transmission, FracTran, purpose-built to meet the unique demands of the hydraulic fracturing industry. This new offering represents another incremental growth opportunity of $100 million in annual revenue. Following the delivery of the first FracTran units to several industry partners during the first quarter, last month, we announced that Calfrac Well Services, one of the largest hydraulic fracturing companies in the world, had introduced FracTran into their field operations beginning in April. Calfrac employees have been impressed and noted an improvement in the productivity of the FracTran-equipped hydraulic fracturing equipment. FracTran's early success in the field, along with customer feedback, reinforces our expectations. Allison's FracTran is the only purpose-built hydraulic fracturing commission in the market and offers a unique combination of versatility, power, and efficiency to maximize customer productivity with high reliability and powerful performance under pressure. Allison's defense end market is also positioned to drive long-term growth. In recent months, we've announced multiple initiatives in support of our defense customers, including the U.S. Army's newest tactical wheeled vehicle program, the common tactical truck, or CTT. Allison will support multiple customers, leveraging our 4000 Series fully automatic transmission. CTT has the potential to replace more than 7,000 heavy-duty trucks within the Army's tactical wheeled vehicle fleet, representing over $150 million in aggregate revenue for Allison. Prototype vehicle testing will begin in late 2023, with an award decision expected to occur as early as 2025. Allison has also been selected to provide the X1100-5B propulsion solution for the U.S. Army's new M88A3 Hercules heavy tracked recovery prototype vehicle that is expected to upgrade and replace the M88A2. This initiative is consistent with the Army's continued investments in combat readiness and fleet modernization. Following the prototype stage of the M88A3 Hercules, a decision by the Army to transition to production is expected as early as 2024. Currently, there are more than 900 M88 vehicles in the U.S. Army. If the Army were to modernize the entire fleet, the total revenue opportunity for Allison could represent nearly $500 million over the next two decades. Last week, we announced that Allison's 3040 MX cross-drive transmission will be featured in the U.S. Army's newest tactical armored combat vehicle, the Mobile Protected Firepower (MPF) program. The MPF program is one of the Army's highest priority modernization initiatives. The Army is expected to purchase more than 500 MPF vehicles through 2035, collectively representing approximately $250 million in revenue for Allison's Defense end market. Allison is proud to team up with General Dynamics Land Systems on the MPF program and to provide the Army with the transformational technology necessary for future battlefields. Allison has consistently been at the forefront of transformational technology. In June, in partnership with GILLIG and Cummins, we announced the delivery of the first transits equipped with Allison's next-generation electric hybrid propulsion system, eGen Flex, to the Indianapolis Public Transportation Corporation. The eGen Flex continues to make inroads throughout the Midwest with multiple transit properties selecting eGen Flex equipped buses for their fleets, including recent announcements with Evansville in Muncie, Indiana, and Oshkosh, Wisconsin. Introduced in 2020, Allison eGen Flex has demonstrated the ability to operate in full engine-off mode for more than 50% of its time in operation across multiple routes within one of North America's largest transit fleets. Allison is proud to partner with public transit agencies across the Midwest to support their efforts to reduce carbon footprints and dependence on fossil fuels, protect the environment, and enhance the quality of life for their passengers. As fleets move to electric hybrid or full EV technology to support sustainability goals, Allison will continue to be a partner of choice, supported by our track record of delivering innovative and reliable technology specifically designed to meet the needs of the transit industry. Earlier in the second quarter, at the Advanced Clean Transportation Expo in Long Beach, California, we were proud to announce a new strategic partnership with Exos, a leading manufacturer and services provider of Class 5 through Class 8 battery electric vehicles, powertrains, charging infrastructure, and fleet management software to jointly develop heavy-duty Class 7 and 8 commercial electric vehicles. Allison's 100S and 100D eGen Power electric axles will be integrated into Exos battery electric commercial trucks. Finally, during the quarter, Emergency One unveiled their fully electric EV0 fire engine equipped with the eGen Power 100D electric axle. This first-of-its-kind vehicle was released in late June and already has orders from the Scottish Fire and Rescue Service with an expectation to enter service in early 2023. Emergency One is the United's largest manufacturer of fire and rescue vehicles, and we are proud to play a key role in their next-generation electric vehicle platform. Thanks to the Allison team's relentless execution over the years and through multiple cycles, we are realizing the benefit of our growth objectives. Our success remains aligned with our long-term strategy of continuous global market expansion. Coupled with continuous product and technology innovation and the Allison brand promise of quality, reliability, and durability, we remain positioned to improve the way the world works for years to come. Thank you, and I'll now turn the call over to Fred.

Thank you, Dave. Following Dave's comments, I'll discuss the Q2 2022 summary, key income statement line items, and cash flow. Please turn to Slide 5 of the presentation for the Q2 2022 performance summary. Year-over-year, net sales increased 10% to $664 million from the same period in 2021, driven by price increases, resilient customer demand, and the continued execution of our growth initiatives despite persistent supply chain challenges. The increase in year-over-year results was led by a 13% increase in the North American On-Highway end market, principally driven by the continued strength in customer demand for last-mile delivery, regional haul, and vocational trucks. Year-over-year results were also improved by a $25 million increase in net sales in the Global Off-Highway end markets driven by sustained demand for hydraulic fracturing applications in the energy sector as well as stronger demand in the mining and construction sectors. An 8% increase in net sales in the Service Parts, Support Equipment, and Other end market, principally driven by North American Service Parts and Global Support Equipment, and a 7% increase in the net sales in the outside North America On-Highway end market, principally driven by higher demand and increasing penetration in Europe and South America. Gross profit for the quarter was $311 million, an 8% increase from the $288 million for the same period in 2021. The increase was principally driven by price increases on certain products and higher net sales, partially offset by unfavorable material costs. Net income for the quarter was $122 million compared to $110 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by increased product initiatives spending. Adjusted EBITDA for the quarter was $227 million compared to $213 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by increased product initiatives spending. Diluted earnings per share increased 25% to $1.26 from the period in 2021 driven by higher net income and lower total shares outstanding. 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 Q2 2022 financial performance summary. Selling, general, and administrative expenses decreased $2 million from the same period in 2021, principally driven by lower commercial activities spending. Engineering, research, and development expenses increased $5 million from the same period in 2021, principally driven by increased product initiatives spending. Please turn to Slide 8 of the presentation for the Q2 2022 cash flow performance summary. Adjusted free cash flow for the quarter was $36 million compared to $95 million for the same period in 2021. The decrease was driven by higher operating working capital funding requirements and higher cash income taxes, partially offset by higher gross profit and lower capital expenditures. The increase in operating working capital funding requirements during the second quarter was driven by increased inventory early in the quarter to mitigate supply chain constraints and position Allison to meet customer demand in the second half of the year. The timing of the inventory increases, and corresponding accounts payable balances paid during the second quarter had an unfavorable impact on operating working capital. Further contributing to the increase in operating working capital funding requirements, net sales experienced a gradual ramp-up as the quarter progressed, with June being the highest revenue month of the quarter. The late quarter cadence in net sales and corresponding accounts receivable balances to be received during the third quarter also had an unfavorable impact on operating working capital. Consistent with Allison's disciplined and well-defined approach to capital allocation, we settled $34 million of share repurchases during the second quarter. Year-to-date, Allison has repurchased 3% of outstanding shares. We ended the quarter with a net leverage ratio of 2.7x, $122 million of cash, and $645 million of available revolving credit facility commitments. In addition, we continue to maintain a flexible, long-dated and covenant-light debt structure with the earliest maturity due in 2026. Finally, we ended the quarter with approximately $1.2 billion of authorized share repurchase capacity. Please turn to Slide 9 of the presentation for the full year 2022 guidance. As Dave mentioned earlier, we are reaffirming the full year 2022 guidance midpoints while narrowing the guidance ranges released to the market on February 16. We expect net sales for 2022 to be in the range of $2.65 billion to $2.75 billion. Our 2022 net sales guidance reflects higher customer demand in the Global On-Highway, Global Off-Highway, and Service Parts, Support Equipment, and Other end markets, as well as price increases on certain products and the continued execution of our growth initiatives. In addition to Allison's 2022 net sales guidance, we anticipate net income in the range of $450 million to $500 million, adjusted EBITDA in the range of $885 million to $955 million, net cash provided by operating activities in the range of $590 million to $660 million, adjusted free cash flow in the range of $420 million to $480 million, and capital expenditures in the range of $170 million to $180 million. Thank you. This concludes our prepared remarks. Kyle, please open the call for questions.

Our first question is from Larry De Maria with William Blair.

Just curious, I wanted to touch on e-axles long term and not specifically the quarter right now, but obviously, comes a Meritor tie-up, which will ultimately lead to an integrated solution, including e-axles. I'm just curious how you're thinking about strategically from your end, if you need to partner elsewhere and how does this change your product development road map and expense plan? And just broadly how you're thinking about your competitive positioning given some of the consolidation?

Larry, it's Dave. So to your question, first of all, the Cummins Meritor deal frankly makes a lot of sense for both parties. I think to your comment there about what they're bringing in terms of integration. I'm sure, as you know, the architecture that we're pursuing in terms of the e-axle is fully integrated e-axle. So I would also note, our ability, as we've done for probably 20 years now, in terms of experience around delivering fully integrated solutions back to the eGen Flex product that we have, which is second generation versus our H 40/50 transit system. We certainly have that experience and capability. We've also talked previously about our efforts to partner in several different areas and frankly, a number of announcements, investments we've made as well as others that we're working on. But we think, certainly, the e-axles as a solution set, given many other technologies that are out there, continues to be preferred for a number of reasons. So we're very pleased with where we are from both a design perspective and the progress that we're making on several engagements. As we mentioned in the prepared remarks, continue to make progress with what we consider to be very focused engagement with the marketplace. But also, I think being very clear-eyed about the expectation, which is the experience of delivering at or better performance than what the industry has come to expect from the industry standard of Allison in terms of performance, durability, reliability, et cetera. So that's really how we see things playing out over the longer term. We believe it will certainly be a significant portion of the market in terms of solutions demand and look forward to delivering products consistent with our brand promise.

Our next question is from Rob Wertheimer with Melius Research.

Could you please update us on just price costs in the quarter and where you feel you are on recapturing the rising cost curve? I don't know if you're a little bit behind maybe some others, maybe OEMs. And then just in general, how do you see the cost curve developing right now in real-time on labor, inflation peaking, transport costs, material costs, or anything else? If you could sort of give us a sense of how that balance and price cost is trending for the rest of the year as far as you can see.

Sure, Rob. This is Fred. For the quarter, we had $33 million in price, had material costs up $25 million, so slightly favorable. We have, as the year progressed, and we talked about on the Q1 call, continue to see cost escalating. Obviously, here recently, you've seen commodity costs start to roll off. But as we look at it, we still feel for the year, we'll be slightly price cost favorable. Obviously, that's had an impact on our margin percentages. When you think about adding roughly $100 million in revenue and close to $100 million in cost, clearly, it's dilutive to margins. So if you just took that into consideration itself, that's diluting our margins by about 130 basis points in impact. And clearly, we have the operating leverage, but we have to overcome that headwind. As we go forward, we haven't seen any signs of inflation letting off. Like I said, you started to see some relief from commodities, but labor rates are continuing in a tight labor market. So as we formulate our thoughts around 2023, I certainly think it's an environment where you're positioned to go out and get price, and we'll need to cover the inflation.

Our next question is from Tim Thein with Citigroup.

Great. Fred, continuing on the topic of pricing and inflation, long-term supply agreements have traditionally been important for Allison to provide more visibility and a bit of a hedge. However, we haven't faced this level of broad inflation for quite some time. As you renegotiate these agreements as they come up, how are you adjusting the terms? I understand there may be limits to what you can share, but my main question is whether there will be changes to any components of these agreements due to the current inflation environment that we haven't seen recently. How are you approaching these agreements as they come to an end?

Thanks, Tim. This is Fred. Certainty in pricing in this environment is tied to cost. As you know, these discussions occur at various times and are typically structured over three to five-year periods. We are open to providing price certainty, but it will come with a cost. Given the current situation, it may be in both parties' interests to consider annual pricing or pricing upon delivery. These discussions are ongoing, and we are mindful of our cost structure, expecting to achieve significant price increases. It's important to note that our product adds value, so when an OEM raises the truck price by 10% or 15%, the value of our product increases accordingly. Similarly, if fuel prices rise, the value of our offering also increases because it enhances fuel efficiency. This means you can accomplish more with vehicles equipped with our product, leading to a reduced need for multiple vehicles in a fleet. Therefore, with our ability to deliver value and a solid payback within two to three years, especially in an inflationary environment, we are well-positioned to monetize that value.

Our next question is from Ian Zaffino with Oppenheimer.

I know you kind of answered this question a little bit, but as you look on the electric side, do you feel like you have any holes where you would need to maybe go out and buy something? And in that vein, how are you thinking about shareholder returns and capital returns in an environment where you may need to make M&A?

Ian, it's Dave. So as we've said, our position has quite a history in terms of electrification. We fast-forward to today, as you know, we've made a number of investments already and continue to invest. We're also certainly fully aware of the potential evolution, adoption of EV and all the variables and attributes that need to be met to do that. We start with, as I said earlier, delivering our brand promise, and it's a very high standard of performance. And as Fred just mentioned, we deliver real value. We see that certainly in the context of EV solutions, which really gets to your question, holes or gaps, if you will, in terms of whether that be capabilities, content, etc., we're constantly looking at improving our overall position. I think it's safe to say based on our history as well as our spending profile, we're moving certainly at a fairly rapid pace with the market. Nevertheless, you're always cognizant of what the returns are, what your return targets are. To your point there in terms of capital allocation more broadly, we have said since prior to going public, as we continue to look at opportunities to invest our shareholders' capital, we have reasonably high expectations there. I think we've proven that through a very disciplined approach. So whatever we consider, whatever we look at is really done in light of those metrics and that evaluation process. We don't see that changing. And we continue with the level of activity that we've had. Certainly, the knowledge that's being built and the awareness of what's in the market, what customers want, I would also offer the voice of customer at some level here remains somewhat incomplete. So we're looking at several different options about how to deliver that brand promise with that voice of customer in mind as it evolves. So I mean I would say more broadly, we're going to continue that analysis, but I certainly can give you some level of assurance that we're staying very close to the market and very active on several different fronts to evaluate those opportunities to improve our overall position in EV.

Our next question is from Jamie Cook with Credit Suisse.

I guess, Dave, question to you, you tend to have a lot of concerns out there on the macro and recessions, and you're starting to see it on the consumer side. You tend to probably be a little more balanced in terms of your views. So I'm wondering, it doesn't sound like you're seeing any cracks, but can you talk to whether you're taking any precautionary measures and the types of things that you're watching just to see if the downturn eventually happens? And then, sorry, a follow-up question. Just wondering, you've made a lot of great announcements and partnerships overseas when you think about EV. We're starting to hear those announcements. Anything pending or coming from your more core customers in North America? Or is it still too far out that there's no point in formalizing anything at this point?

Thank you, Jamie, for your questions. Regarding your comment about potential issues in the market, specifically the North American highway market, other reports have covered the overall conditions and expectations well, and we largely agree with that perspective. While there may be some differences in certain segments, it's important to note that the over-the-road market in North America is not one we operate in. The activity seen there aligns with the current situation regarding used vehicle values. Overall, the market has been undersupplied for some time. Our understanding is that any cancellations are being managed by waitlists, and OEMs still have full order books. From a scheduling perspective, this is a favorable position, provided we can resolve ongoing supply constraints. We view this as a healthy environment moving into 2023. Additionally, the emissions changes for 2024 should further support the broader market. That said, we maintain a cautious outlook. Many team members experienced the downturn of 2008 and 2009, and we've since taken steps to be better prepared. Our organizational flexibility remains high, thanks to the efforts in optimizing our operational footprint both in North America and abroad. We are vigilantly monitoring the situation. Furthermore, government spending remains relatively high, creating some supportive conditions in certain areas. The main challenge continues to be the input constraints already discussed on the call and how they will be addressed. Regarding our EV partnerships, we are actively pursuing additional opportunities and will provide updates as the year progresses. Our team is doing an excellent job managing these engagements with focus. It's worth noting that input constraints aren't limited to the conventional market; the EV sector is also facing challenges, particularly with the volumes being requested. This makes it difficult, especially regarding lower volume products in the conventional market that are struggling to meet demand.

Our next question is from Jerry Revich with Goldman Sachs.

Fred, I'm wondering if you could just talk about the margin cadence that you're expecting over the course of this year. I think normally, your margins are about flattish 2Q with 1Q. This year, we were down 1.5 points. Can you just talk about the sequential drivers? And then how you're thinking about margin progression heading into 3Q, where under normal seasonality, you're typically flattish 3Q versus 2Q?

Sure, Jerry. As we're looking at it right now, we see Q3 very similar to Q2, and then with the outlier being Q4. That's really driven by the number of production days, the holidays around Thanksgiving into the year. So the cadence looks fairly balanced, Q2, Q3, and Q4 tailing off slightly, really driven by top line revenue, Jerry.

And Fred, could you just say more about the progression 2Q versus 1Q? Why did we have a margin step down? Was that supply chain? Or what drove the step down 2Q versus 1Q?

If you look at the quarters, we did continue to see, and we saw some cost increases Q1 to Q2. From our suppliers, commodities continue to elevate. Volume was slightly lower. So those are the primary drivers.

Our next question is from Felix Boeschen with Raymond James.

I was hoping we could maybe expand a little bit on the supply chain commentary. I think in the prepared remarks, you had noted they really haven't gotten uniformly better. But just curious if you could talk about maybe pain points in your own supply chain and what you're hearing on the OEMs from a planning perspective into the second half of the year. Appreciate it.

You're welcome. Felix, it's Dave. I want to begin by reiterating something I mentioned during our first quarter call regarding the significant effort the industry is putting into managing current constraints. I want to acknowledge the hard work of the Allison team, our supply partners, and our customers who are collaborating to navigate these challenges. In my experience with the business, I've never seen such a level of intensive coordination required. This process is time-consuming and is also leading to additional costs in various areas. However, nothing specific is causing major issues for us. Industry-wide, electronics continue to pose challenges. Recent surveys indicate that while the availability of raw materials has decreased slightly among the top five suppliers, labor availability has improved. It's important to think beyond just components; we need to consider all inputs, and labor remains a critical factor. In North America, we're experiencing some disruptions due to the unfortunate lockdowns in China and ongoing energy issues, but we are not significantly affected at this moment. OEMs, despite their best efforts, need to consider the entire supply chain for their components, reflecting the complex nature of our global supply chain. As we mentioned in our prepared remarks, we don’t anticipate major improvements in this area soon. However, on a positive note, the demand and scheduling are easing some pressure by aligning more with supplier availability, leading to a preference for higher-margin products over lower-margin ones. We expect this trend will eventually balance out as we work to meet customer demand. Overall, while challenges persist, the situation is somewhat better than in previous quarters. We'll see what tomorrow brings, as each day can be unpredictable.

Our next question is from Tami Zakaria with JPMorgan.

So going back to that Exos partnership with 100S and 100D, can you just remind us what the revenue opportunity you see with this partnership? And what kind of margin do you expect from this versus the conventional business?

Tami, it’s Dave. I guess a few things. We do not get ahead of our customers. So I would certainly point you to Exos as they develop their forecast and ultimately talk to vehicle development time lines and programs. That's really the answer to your question. In terms of margins, as we've over the years learned full well, we didn't achieve the margins that we had today immediately in terms of product introduction. I'm fairly confident others that are providing several different solutions in the EV space right now are feeling that same position in terms of addressing cost for relatively low volume introductions. I would say a number of the announcements that have been made aren't even by industry standards low rate initial production; they're more in the concept or design validation stage than they are the start of production type of number. So that, by definition, leads you to a path of relatively low expectations initially in terms of margins on these types of solutions.

We have reached the end of the question-and-answer session. And I'll now turn the call over to Dave Graziosi for closing remarks.

Thank you, Kyle, and thank you for your continued interest in Allison and for participating on today's call. Enjoy your evening.

This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.