Allison Transmission Holdings Inc Q3 FY2022 Earnings Call

Good afternoon. Thank you for standing by. Welcome to Allison Transmission’s Third Quarter 2022 Earnings Conference Call. My name is Shamali, and I will be your conference call operator today. After prepared remarks, Allison Transmission executives 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 Jackie Bolles, Executive Director of Treasury and Investor Relations, who has been recently appointed to the role. Please go ahead, Jackie.

Thank you, Shamali. Good afternoon, and thank you for joining us for our third quarter 2022 earnings conference call. With me this afternoon are David 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 allisontransmission.com. A replay of this call will be available through November 2. 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 third quarter 2022 earnings press release, our annual report on Form 10-K for the year ended December 31, 2021, our quarterly report on Form 10-Q for the quarter ended March 31, 2022, geopolitical uncertainties and related responses by governments, customers and suppliers as well as other general economic factors. 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 third quarter 2022 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 just 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 third quarter 2022 results and provide a brief operational update. Fred Bohley will then review our third quarter financial performance and review updates to the 2022 guidance prior to commencing the Q&A. Now I’ll turn the call over to Dave Graziosi.

Thank you, Jackie. Good afternoon, and thank you for joining us. We are pleased to report our third quarter results, which reflect ongoing strength in our end markets and the continued focus of our team to drive results, though the operating environment continues to be challenging. The resiliency of customer demand is demonstrated by a 25% year-over-year increase in revenue to $710 million for the third quarter. Notably, year-over-year net sales growth was surpassed by even stronger growth in diluted EPS, up 63% as 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. Despite concerns of a slowdown in economic activity, customer demand remains robust with industry production limited primarily by persistent supply chain constraints. We anticipate that 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. As a result of the ongoing strength in Allison’s global on- and off-highway end markets, we are pleased to raise the full year guidance while narrowing the guidance ranges provided to the market on August 3. During the quarter, we announced changes to refresh our Board of Directors by adding four new members in early August with four current members serving out their term, not standing for reelection at our 2023 annual meeting. The changes reflect a deliberate process by the Board to recruit new directors who will complement the overall mix of skills, knowledge, experience, and perspectives. We are pleased that we have identified four outstanding independent directors who each bring extensive experience in areas relevant to our business and will be great assets to Allison. In prior quarters, we emphasized programs that have gained traction and are driving revenue growth in our conventional business with a combined potential incremental growth opportunity of $250 million in annual revenue. In addition to the 3414 Regional Haul, FracTran, and China widebody mining dump initiatives covered in previous quarters. Today, we will highlight new opportunities for our conventional products as well as provide an update on our electrified propulsion portfolio. As we recently announced, Allison has been named the exclusive provider of transmissions for XCMG’s all-terrain crane application. As one of the top three largest construction machinery manufacturers in the world, XCMG has already integrated the Allison 4970 Specialty transmission into dozens of its new all-terrain cranes and is seeing outstanding performance, leading to continued growth in the Outside North America On-Highway market. During the quarter, Isuzu unveiled their new medium-duty FVR truck in Taiwan that features the Allison 3000 Series six-speed automatic transmission. The new Isuzu FVR truck was designed to tackle high stop-start duty cycles and numerous application demands, making the Allison 3000 Series a proven choice of propulsion to ensure fuel efficiency, enhanced maneuverability, and increased ability to move heavy loads in urban environments. We are pleased to continue our outstanding partnership, and we are confident that the Isuzu and Allison combination will deliver superior economic value to fleets across Taiwan. Additionally, in our Outside North America On-Highway market, we continue to see growth opportunities in the agriculture sector since entering the market in 2015. In South America, leading OEMs, including Cameco, John Deere, and Metalfor have chosen the Allison 2000 and 3000 Series transmissions for their agricultural sprayers. As OEMs have made the transition from manual transmissions, customers and drivers that operate ag sprayer vehicles have benefited from integrating the Allison fully automatic transmissions due to enhanced performance in soft soil, which is critical in this application. The agribusiness in South America continues to be an exciting growth opportunity for Allison, and we look forward to providing transmissions designed to meet the unique challenges of the industry. In September, Allison participated in the IAA Transportation Conference in Hanover, Germany, where we announced the latest addition to our eGen Power family, the 130S, joining the eGen Power lineup of electric axles, which includes the 100D introduced in 2020, the 130D, and 100S, both introduced in 2021. The 130S includes new key components designed to specifically support the heavier 13-ton gross axle weight rating often required by commercial vehicles in the European and Asia Pacific markets. The introduction of the 130S is representative of Allison’s global approach to electric vehicle propulsion, and we are pleased to expand our eGen Power family of e-axles to deliver additional fully electric solutions for the European and Asia Pacific markets. Also at the IAA Transportation Conference, we announced the eGen Power 130D e-axle was chosen as the propulsion solution for Quantron’s new fuel cell electric vehicle. The Quantron FCEV will utilize the 130D to support sustainability initiatives of customers and drive growth in our electrification portfolio. The implementation of the eGen Power family into fuel cell electric vehicles is a testament to Allison’s energy-agnostic e-axle portfolio of propulsion solutions, which pair well with any source of energy. Furthering our capabilities to support the development of alternative fuel vehicle solutions, we announced this quarter that our vehicle electrification and environmental test center is now capable of both testing and providing hydrogen supply for fuel cell vehicles. We are excited to expand the facility's capabilities to support our OEM customers as they develop and optimize alternative fuel offerings intended to reduce emissions. During the quarter, we announced our strategic cooperation agreement with Anadolu Isuzu, Turkey’s leading bus and truck manufacturer. As part of the agreement, Allison’s eGen Power 100S will be incorporated into Anadolu Isuzu’s light-duty truck and midibus platforms for refuse, distribution, and public transportation applications. Allison’s conventional transmissions have been a preferred solution for their bus platforms for more than a decade, and we are excited to expand our offering and continue our long-standing relationship by delivering innovative solutions to our customers. Early in the quarter, we announced the award of a $6.5 million contract from the U.S. Army’s Ground Vehicle Systems Center. This award will be used to support the design, development, and testing of our newest addition to the eGen portfolio, the eGen Force. Allison has combined its decades of experience in both combat vehicles and electric hybrid propulsion solutions to develop the new eGen Force electric hybrid system, designed for 50-ton tracked vehicles. The eGen Force meets the requirements for the U.S. Army’s optionally manned fighting vehicle program and has been selected as the propulsion solution for the American Rheinmetall Lynx vehicle. The eGen Force is also scalable to 70-ton tracked vehicles, making it capable of meeting future main battle tank requirements as well. Finally, the eGen Flex, our zero-emission capable electric hybrid system that provides bus fleets with the optionality of a full electric engine propulsion for up to 50% of the duty cycle, continues to gain share across transit properties in the United States. We recently announced that the Santa Clara Valley Transportation Authority has selected the eGen Flex propulsion system for its fleet of transit buses. This order represents the largest and most recent in a series of nationwide awards for buses equipped with Allison’s next-generation electric hybrid system. As we have often said, there are more growth and technology initiatives happening at Allison today than at any other time in our history. We continue to invest across our portfolio to drive growth and deliver value propulsion solutions to all of our end markets. Thank you, and I’ll now turn the call over to Fred.

Thank you, Dave. Following Dave’s comments, I’ll discuss the Q3 2022 performance summary, key income statement line items, and cash flow. I’ll then review updates to full year 2022 guidance. Please turn to Slide 5 of the presentation for the Q3 2022 performance summary. Year-over-year net sales increased 25% to $710 million from the same period in 2021, driven by resilient customer demand, price increases, and the continued execution of growth initiatives. The increase in year-over-year results was led by a 24% increase in the North American On-Highway end market, driven by continued strength in customer demand for last-mile delivery, regional haul, and vocational trucks. Year-over-year results were also improved by a 25% increase in the net sales in the service parts, support equipment, and other end market, principally driven by global service parts and support equipment, and aluminum die-cast components, as well as a $26 million increase in net sales in the Global Off-Highway end markets, driven by demand for hydraulic fracturing applications in the energy sector, as well as higher demand in the mining and construction sectors. And a 27% increase in net sales and record quarterly revenue in the Outside North America On-Highway end market, driven by the continued execution of growth initiatives in Europe, Asia, and South America. Gross profit for the quarter was $328 million, a 26% increase from $261 million for the same period in 2021. The increase was principally driven by increased net sales, and price increases on certain products, partially offset by higher direct material costs. Net income for the quarter was $139 million compared to $94 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by an unrealized loss on marketable securities and increased product initiatives and commercial activity spending. Adjusted EBITDA for the quarter was $245 million compared to $189 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by increased product initiatives and commercial activity spending. Diluted earnings per share increased 63% to $1.45 from the same 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 Q3 2022 financial performance summary. Selling, general, and administrative expenses increased $5 million from the same period in 2021, principally driven by higher commercial activity 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 Q3 2022 cash flow performance summary. Adjusted free cash flow for the quarter was $182 million compared to $153 million for the same period in 2021. The increase was driven by lower capital expenditures and higher net cash provided by operating activities. Consistent with Allison’s disciplined and well-defined approach to capital allocation, we repurchased $109 million of our common stock during the third quarter, representing 3% of outstanding shares. We ended the quarter with a net leverage ratio of 2.5x, $180 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 $1.1 billion of authorized share repurchase capacity. Please turn to Slide 9 of the presentation for the 2022 guidance update. As Dave mentioned, given third quarter results and current end market conditions, we are pleased to raise the full year 2022 guidance while narrowing the guidance ranges released to the market on August 3. We expect net sales for 2022 to be in the range of $2.69 billion to $2.74 billion. Our 2022 net sales guidance reflects higher customer demand in 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 $490 million to $510 million, adjusted EBITDA in the range of $915 million to $945 million, net cash provided by operating activities in the range of $620 million to $650 million, capital expenditures in the range of $160 million to $170 million, and adjusted free cash flow in the range of $460 million to $480 million. Thank you. This concludes our prepared remarks. Shamali, please open the call for questions.

Glad to see a lot of strength still continuing. Can we just key in on pricing? Can you maybe talk about the magnitude of some of your pricing you saw in the quarter? And maybe what areas? And what’s the outlook for the fourth quarter and beyond from a pricing standpoint?

Ian, this is Fred. For the quarter, on a year-over-year basis, pricing was favorable $29 million. As we look at full year at this point, previously talked about 400 basis points of pricing. We have taken some pricing within the year and are now anticipating about 425 basis points of price. So roughly $115 million in price on a year-over-year basis. As we talked about on previous earnings calls, as OEMs continue to raise the price of vehicles, and our transmission makes those vehicles more productive, more efficient from a fuel standpoint, they’re able to get more work done. It just increases the value of our transmissions. So we certainly feel well-positioned to continue to capture price in this inflationary environment.

Great. And welcome aboard to Jackie. Maybe Dave, just on the Global On-Highway, the strength you saw there, which presumably there’s some amount of currency headwind that would even flatter and even more when adjusting for that. But what do you attribute that? It’s not contract wins you would have gotten this quarter, obviously, but much of that is strength in maybe China? Well, China, I think, on-highway is actually worse in the quarter for the industry. So what areas of the country or not in the country or the world that you highlight in terms of driving that strength, your continued strength rather? And what kind of visibility is always a challenge in the on-highway space, but what do you have? Are you looking forward to that specific market in ‘23? How do you kind of size that up?

Thank you, Tim. Let me quickly provide an overview. In North America, I believe you've seen the public reports discussing current market conditions, which are relatively strong. The significant backlogs stemming from production issues dating back to 2020 and into 2021 certainly support our expectation for a healthy market in the near to medium term. This strength is broad-based for us, particularly in the vocational space, which remains robust even before the infrastructure legislation takes effect. Overall, North America remains a solid market. Outside North America, our team has done an excellent job supporting customers across various markets. We have experienced asymmetric reopenings and some interim pauses in Asia that you may be aware of. We've worked hard to ensure that end users and OEMs can stay operational, given the availability of products and components. Overall, I wouldn't categorize any market outside North America as weak; rather, they all appear relatively strong. Regarding the 2023 guidance, we'll discuss that during the fourth quarter call and the first quarter. I won't preview it now, but based on ongoing market conditions, particularly concerning the supply chain challenges, we anticipate a favorable outlook heading into 2023. Additionally, as I mentioned earlier, our growth initiatives are progressing well, and we are happy with the outcomes. Specifically in China, this market includes both domestic truck sales and exports, particularly in mining and buses, and performance has been decent this year. We will continue to monitor the situation as we approach the year's end, but overall, the market remains relatively strong.

I have two questions. First, I noticed a 25% increase in the parts and service business this quarter. Can you explain the factors driving that growth? How much of it is due to market conditions versus pricing? How sustainable is this growth considering its positive impact on your margins? My second question is for Dave. Given the strength of the balance sheet, cash flow, and the declining valuations in the market, could you provide an update on the M&A opportunities you are observing? Is there a chance for Allison to pursue more acquisitions compared to the past?

Jamie, this is Fred. Relative to the strength on the service parts, support equipment, and other was primarily driven by the service parts, but we also had, obviously, a strong unit volume. So the support equipment used to support the initial installation was up. And we were also up with aluminum die-cast components. So it was pretty broad-based. It was definitely a strong quarter. Candidly, a little stronger than we had anticipated when we forecasted things.

Jamie, it's Dave. Regarding your question about our balance sheet and capital allocation in relation to M&A opportunities, we are closely monitoring the market and our contracts. As you know from following us over the years, our business continues to expand beyond just transmissions. Allison is more than a transmission company; we view ourselves and the market in a broader context. I see numerous opportunities for our team to create value for our shareholders. However, we are patient and disciplined, and we expect to encounter opportunities that align with appropriate valuations. Additionally, considering the current market cycle, there is significant activity in our core markets. Therefore, I believe there will be various opportunities, though it remains uncertain whether they will materialize in the near term due to broader market conditions.

I wanted to ask about two things, I guess, on the advanced powertrain side. One is, I don’t know if you have an update on eGen Flex and just the hybrid transmission and whether that’s kind of a growing market or a legacy market where fleets have adopted it, continue to replace and expand with it or if it’s real growth. And then just more generally I’d love it if you could just give us an update. You’ve been very active across advanced powertrain on the state of the market, whether customers are buying for efficiency, where you see your market positioning, where you see your win rates and the things that you want to win, just the general state of development.

Thank you for the questions, Rob, it’s Dave. Regarding the eGen Flex, this product has a legacy that spans about 20 years. It was quite unique at that time, and currently, there are over 9,000 systems in operation worldwide. The eGen Flex represents the next iteration of what was previously known as the H4050. The main enhancement with the eGen Flex is the addition of full electric vehicle capability for up to 10 miles, along with various features that improve performance by around 50% in EV mode on a duty cycle. Consequently, this product is significantly more advanced and aligns well with environmental regulations. In summary, it's a successor product that incorporates several marketplace-responsive improvements and positions us for the future while considering our legacy market presence. Regarding the broader advanced powertrain sector and our opportunities, we've noticed a strong level of interest in our eGen Power series of e-axles. As I mentioned in the prepared remarks about Hanover, our team had an impressive showing at the event, attracting considerable traffic and engaging in many valuable meetings. Our products received significant attention, particularly in comparison to competitors. Additionally, as I noted, we are strategically selective about our partnerships, focusing on maintaining our power agnostic approach while keeping in mind our commitment to the Allison brand, which is known for its high quality and reliability. We believe that any alternative or advanced powertrains we introduce will meet or surpass the conventional standards we’ve established. Overall, we are excited about our team’s reception in the market and the progress we're making. We continue to capitalize on investments made over the last few years, including acquisitions, new talent, and additional facilities, such as our team in Auburn Hills and our unique vehicle electrification and environmental test center in Indianapolis. While we see numerous opportunities ahead, it's important to recognize that we are still in the early stages of some powertrain solutions. We're prepared to be patient and ensure we approach this in line with our brand promise.

I’m curious about some of the opportunities from a revenue perspective. You’ve called out the regional haul, the dump body initiative in China, and the FracTran. I think it’s about a $250 million revenue opportunity all in. Just kind of curious if you can maybe give us an update on those three launches, what may or may not already be in the numbers versus what’s sort of slated to come online in the coming years would be super helpful.

Sure, Felix. This is Fred. As you can imagine, they are all at different stages. The regional haul has been around for a couple of years, and we have achieved releases with Navistar, Daimler, and Volvo. What’s notable is a couple of OEMs. The widebody mining dump in China has seen quite fast adoption, while the FracTran is still in early stages of launch. For the $100 million opportunity from FracTran, there is no revenue in the current run rates. Regarding the widebody mining dump, it will be interesting to see how we finish the year, as we had targeted $50 million. There has been quick adoption, and I think we’ll probably be halfway there, possibly undershooting the potential opportunities. We continue to explore that. In the regional haul, we have made several key releases, and customers have tried five to ten units, which is typical in the conventional market, especially in North America. Conservative end users are making repeat purchases. We're probably about 10% of the way toward that $100 million target, so there’s a lot still ahead of us. Additionally, as Dave mentioned in the prepared remarks, there is significant ongoing activity. We are experiencing record growth in Outside North America On-Highway and Defense business, where we've made substantial investments. Some of those programs, such as the M88 and MPF, are starting to show results, especially with Western European OEMs looking to rebuild their fleets given the conflict in Ukraine. There are plenty of opportunities as those using Russian equipment are often seeking alternative sources. We are very pleased with the progress on those three initiatives, but there is still much more potential to advance this conventional business.

So my first question is, how should we think about your gross margin rate in the fourth quarter? Because it seems like gross margin rate erosion has finally inflected, and you had leverage in the third quarter after several quarters. So any thoughts on how you’re thinking about gross margin in the fourth quarter? And then also next year, maybe given some of the commodity prices are coming down.

Tami, this is Fred. As we approach the fourth quarter, I’m sure you’ve calculated the implied guidance. Typically, the fourth quarter tends to be one of the weakest due to the reduced number of production days around the holidays. We anticipated this trend for this year. Additionally, we are beginning to see some commodity prices decrease, which should lead to favorable pricing and costs in the fourth quarter. In relation to 2023, we are putting in considerable effort regarding our projections. We expect to secure pricing, but we will also continue to analyze the top line and cost structure. We will share more details when we release our Q4 results in February along with our initial guidance for 2023.

Tami, it’s Dave. In response to Fred's comments, we are working on several programs, both through the U.S. government and internationally. I believe you should start to see an increase in Defense over the next year or two. If everything is funded and on schedule, especially with tracked programs, we expect a significant ramp-up compared to the past decade, where much of our Defense business was primarily wheeled in terms of volume. Our team has dedicated the last four to five years to expanding our presence in the U.S. and internationally. Additionally, the challenging situation in Ukraine has opened up a new market opportunity for Allison. We're eager to see substantial growth from our Defense portfolio at this time.

I’m wondering if you can just talk about the fourth quarter sales outlook at the midpoint of the range, I think you’d be down mid-single digits sequentially, which is worse than seasonality we’ve seen over a number of years. I’m wondering, is that just a function of allowing the supply chain room to execute? Or are there any end markets specifically where you’re expecting lower deliveries? And similar question on margins. So the midpoint implies margins are down 200 basis points sequentially. And I’m wondering if you can talk about are there discrete items driving that? Or is that again, just to provide room to execute given the supply environment.

Jerry, this is Fred. Yes, I think it’s important to note that we have increased our guidance for revenue, earnings, and cash. However, as we analyze Q4, we anticipate revenue will be much closer to Q2 levels. In Q3, we recorded $710 million, which was one of our strongest revenue quarters ever. We expect Q4 to show a decline, which I consider typical seasonality, even though last year was exceptional with Q4 being our highest revenue quarter. When examining the different end markets, nothing seems to stand out specifically. Parts of support equipment showed strength in Q3, and we don’t expect to maintain that level. We foresee a decline in North America Off-Highway quarter-over-quarter. Regarding your question on margins, the primary factor is the reduced revenue and the drop-through effect in Q4. As I mentioned, it’s common for Q4 to be our lowest margin quarter of the year.

Just wanted to discuss gross margins a bit more broadly. Could you walk us through some of the changes over the past few years that have impacted gross margin and sort of break them out by what’s more cyclical or structural? And then within those moving pieces, what do you see coming back that could drive margin to return to more historical levels?

It really depends on the timeframe you consider. The main challenge with margins has been the substantial cost increases that started mainly with raw materials. We've mentioned in past calls that if raw materials return to pre-pandemic levels, we could see an improvement of about 200 to 225 basis points in our gross margins. We have mechanisms in place within many of our long-term supply agreements to pass through costs related to these commodities, but we do not pass through the full amount, and not all of our business is covered by these agreements. As raw material costs have risen, we’ve only been able to pass through approximately 60% through our surcharge method, which typically lags by 6 to 12 months. We're beginning to see some decline in commodity prices. In the short term, we don’t need to pass those costs on, and when we do, it will be at a rate of $0.60 for every dollar. That's had the most significant impact. The second factor is general operational inefficiencies caused by supply chain challenges and our customers’ struggles to produce what they need. This creates inefficiencies for both our suppliers and our manufacturing operations. As we strengthen our supply chain, I believe there are costs that we can eliminate moving forward.

And we have reached the end of the question-and-answer session. I will now turn the call back over to David Graziosi for closing remarks. Thank you, Shamali, and I thank all of the call participants for your continued interest in Allison and for participating in today’s call. Enjoy your evening.

This concludes today’s remarks. If you have any questions, you may disconnect your lines at this time. Thank you for your participation.