Earnings Call Transcript - CMI Q2 2021

Operator, Operator

Good day and thank you for standing by and welcome to the Q2 2021 Meritor Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Todd Chirillo, the Senior Director of Investor Relations. Thank you. Please, go ahead, sir.

Todd Chirillo, Senior Director of Investor Relations

Thank you, Felicia. Good morning, everyone, and welcome to Meritor's second quarter fiscal year 2021 earnings call. On the call today we have Chris Villavarayan, CEO and President; and Carl Anderson, Senior Vice President and Chief Financial Officer. The slides accompanying today's call are available at meritor.com. We'll refer to the slides in our discussion this morning. The content of this conference call, which we're recording, is the property of Meritor Inc. It's protected by U.S. and international copyright law and may not be rebroadcast without the express written consent of Meritor. We consider your continued participation to be your consent to our recording. Our discussion may contain forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995. Let me now refer you to slide two for a more complete disclosure of the risks that could affect our results. To the extent we refer to any non-GAAP measures in our call, you'll find the reconciliation to GAAP in the slides on our website. Now, I'll turn the call over to Chris.

Chris Villavarayan, CEO and President

Thanks, Todd. Good morning, everyone, and thank you for joining us today. Let's turn to slide three. We had strong results this quarter, with $983 million in sales and an adjusted EBITDA margin of 11.3%. Total company sales were up 13% year-over-year, as truck demand increased in all our global markets. Free cash flow performance was excellent this quarter, coming in at $47 million. This was one of our highest second quarter cash flows since we began the implants in 2013. Once again, the Meritor team demonstrated its ability to successfully respond to markets. Even with the sharp increase in volumes and supply chain challenges, we maintained excellent delivery and quality performance for our customers while converting increased sales to profits at expected levels. Looking at the full fiscal year, we're holding our sales, margin, and cash flow guidance, despite indications that we will have one of the largest unfavorable steel impacts we have seen, in addition to higher expenses in electric powertrain development, as we ramp up production capabilities to meet the increasing demand. Carl will provide more detail, but our ability to offset these headwinds reflects the consistent strong execution you expect from us. We have a brand-new electrification program to announce this quarter, in addition to an exciting new opportunity to accelerate the development of our 17Xe electric powertrain in Europe. And in our core business, we have recently finalized long-term agreements with two global OE customers. Please move to slide four. In the second quarter, we extended our agreement with Navistar through 2026. We are pleased to continue our long-standing relationship with Navistar as it becomes part of the Traton family. This agreement extends our current relationship while providing opportunities for future growth in our major product categories of axles, brakes, and drivelines. We also completed a new agreement with IVECO in Europe through 2024. This includes the supply of single reduction axles and strengthens our successful business relationship between our companies. It also provides the opportunity for future growth on other product lines. With Navistar and IVECO complete, most of our long-term agreements with major customers have been renewed well past the 2022 time frame. Moving to electrification on slide five. We are pleased to announce a new collaboration with Hexagon Purus Systems, a global leader in zero-emission e-mobility. Hexagon will integrate Meritor's 14Xe powertrain into its Class 6, Class 7 box trucks, and Class 8 6x4 vehicles starting in 2021. Customers, including PACCAR, AutoCar, and Volta trucks have chosen Meritor's 14Xe integrated electric powertrain. We believe this is market validation of its industry-leading performance. In early 2020, we announced an agreement with PACCAR to be the initial launch partner and supplier for the integration of the fully functional battery electric systems on the Kenworth T680 and Peterbilt 579 and 520 electric vehicles. We have begun prototype production and PACCAR is performing validation testing on its test tracks. It's very exciting for us to see these fully electric vehicles being assembled. Soon these and many others with Meritor's preferred electric powertrain solutions will be fully operational on roads and highways. Please take a minute to view a video of this truck in motion on meritor.com. This footage was shot last week at our Escondido, California facility. With market adoption growing for our 14Xe, we're now shifting the focus to the development of the 17Xe platform in Europe. Last month, we learned we were a grant recipient of the advanced propulsion center in the United Kingdom. This grant will partially fund the development of Meritor 17Xe. After a comprehensive months-long nomination and consideration process, we were thrilled to be selected along with our consortium partners Danfoss Editron and Electra Commercial Vehicles. This grant totaling almost £16 million will rapidly accelerate the development of this product, which is designed for multiple vehicle platforms and extend our ability to offer Meritor's e-powertrain solutions for the European market. We believe demand for this product will grow because of the EU 2025 CO2 reduction targets. Stricter targets will start applying in 2030 and by 2040 all new trucks sold in Europe will need to be fossil-free to reach carbon neutrality by 2050. The 17Xe is another significant step towards completing our electric powertrain portfolio. Carl, will now provide details on our financial results.

Carl Anderson, Senior Vice President and Chief Financial Officer

Thanks, Chris, and good morning. On today's call, I will review our second quarter financial results and provide an update to our fiscal year 2021 outlook. As Chris mentioned at the beginning of the call, we delivered another quarter of strong financial performance. The adjusted EBITDA margin was 11.3%, and we generated $47 million of free cash flow. Now, let's review our financial results compared to the prior year on slide 6. Before I continue, I want to highlight a revision we are making to our presentation of two non-GAAP measures, adjusted income from continuing operations and adjusted diluted earnings per share. To better align with SEC guidance, we will no longer include in non-GAAP measures the adjustment for non-cash tax expense related to the use of deferred tax assets in jurisdictions with net operating loss carryforwards or tax credits. It is important to note, this is a change to our reporting metrics only as the underlying availability and benefit of tax attributes to offset future taxable income has not changed. We expect to maintain an effective cash tax rate of approximately 15% through the M2022 planning cycle. In the appendix, we have also updated prior periods to reflect this change providing for consistent comparatives. Now let's review the details of our financial results. Beginning with the total company, revenue came in at $983 million, up $112 million from the same period last year. As economies rebounded globally, we saw increased truck production in all of our markets. Net income from continuing operations was $63 million, compared to $240 million last year. As a reminder, prior year results include $203 million of after-tax income related to the termination of the distribution arrangement we had with WABCO. This was partially offset by the recognition of value-added tax credits in our wholly owned Brazilian entity of $22 million or $15 million net of tax during the second quarter of fiscal year 2021. Adjusted EBITDA for the second quarter was $111 million, which translates to an adjusted EBITDA margin of 11.3%, a decrease of 100 basis points from the prior year. Adjusted EBITDA this quarter excludes the $22 million Brazil value-added tax credit I previously mentioned. The decrease in margin was primarily driven by an approximately $20 million impact from incentive compensation costs compared to the prior period. Keep in mind, last year we significantly reduced our incentive compensation accrual at the onset of the pandemic. Additionally, we experienced higher freight costs compared to a year ago. This higher expense was offset by cost reduction actions executed in the second half of last year. Overall, we were pleased with our margin performance, especially given some of these cost headwinds. Adjusted diluted earnings per share was $0.68, up $0.04 from last year. And free cash flow for the quarter was very strong at $47 million. Last year we generated $292 million of free cash flow, which included $265 million related to our distribution agreement termination. If you adjust for the one-time impact from last year, free cash flow improved $20 million year-over-year. Based on our market outlook and expectations on cash flow generation going forward, we are in a position to return to a more normalized level of cash on our balance sheet. We therefore are announcing the redemption of the remaining 6.25% notes due in 2024. The $175 million principal balance will be redeemed at the call price of just over 101%, utilizing available cash on hand, which was $321 million at the end of the second quarter. Our objective of maintaining BB credit metrics through market cycles was reinforced this past year, as we were able to successfully manage through the onset of the pandemic. Upon completion of the debt repurchase, our gross debt balances will be similar to where we were pre-COVID. We were also on track for net leverage to be approximately two times this year and plan for a further step down in 2022. Now let's look at our segment results compared to the same period last year. Sales in commercial truck increased by 23%, driven by higher global truck production in all markets. Segment adjusted EBITDA for commercial truck was $73 million, up $15 million from last year. Segment adjusted EBITDA margin increased to 9.4%, an increase of 20 basis points over the prior year. The increase in segment adjusted EBITDA and EBITDA margin was driven primarily by conversion on higher revenue and by cost reduction actions executed last year. This was partially offset by higher incentive compensation and freight costs. Aftermarket and industrial sales were $247 million in the second quarter, down $30 million compared to the prior year. The decrease in sales was primarily driven by the termination of our distribution arrangement, which occurred in the second quarter of fiscal year 2020. Segment adjusted EBITDA was down $12 million compared to the second quarter of 2020 and segment adjusted EBITDA margin decreased to 13.8%. The decreases were driven primarily by the impact from the termination of our distribution arrangement and increased incentive compensation costs, partially offset by cost reduction actions. Before I review our current global market outlook on slide 7, I want to provide an update on supply chain constraints in the markets we are closely monitoring. Global supply chains, primarily for semiconductors have become constrained during this global production upturn. This has affected many global manufacturing industries including commercial trucks. We are seeing some impact to production schedules as a result. In India, the current wave of the pandemic is having a significant impact on the country, which could affect the ability of our OE customers and suppliers to manufacture in the short run. Demand, however, remains high in all of our markets. In particular, order activity in the North America Class 8 market continues to be robust, averaging over 40,000 units per month in our fiscal second quarter and cancellation rates remain very low. Overall, as we assess all of the positives and negatives, we are keeping our global production outlook unchanged as we balance strong global demand with potential supply chain constraints. Let's turn to slide 8 for an update on our fiscal year 2021 outlook. Consistent with our market assumptions, we are holding forecasted sales to be in the range of $3.65 billion to $3.8 billion unchanged from our prior forecast. We are also maintaining our adjusted EBITDA margin guidance steady at an expected range of 10.6% to 10.8%. We are however seeing steel costs continue to increase. Since September hot-rolled coil prices have increased more than 130% and scrap prices are up nearly 100%. The price movement in steel has been the most severe and rapid increase we have seen over the past 10 years. As a result, we now anticipate a full year headwind of $25 million to $30 million in higher steel costs, up $10 million from our prior review. Most of this impact will be felt in our third fiscal quarter as prices begin to reset with our steel suppliers. While this is a significant headwind in 2021, we do have a pass-through mechanism in place with our customers, which are typically on a three- to six-month lag. We expect to see most of this recovery beginning in early fiscal year 2022. Additionally, we are increasing our electrification spend between $5 million to $10 million from our prior guidance as we continue to respond to this growing opportunity. While we are experiencing these higher costs, we expect to be able to offset most of these increases through continued operational performance. Our purchasing team has done an excellent job in driving material performance savings and we continue to see the benefits from cost reduction actions executed last year. Moving to adjusted diluted earnings per share, our outlook for 2021 is now in the range of $2.15 to $2.30. This reflects the impact from the adjustment for non-cash taxes as well as the lower interest expense expected from the bond redemption. Our effective cash tax rate of approximately 15% in fiscal 2021 remains unchanged. And finally, we are maintaining our expectation to generate between $110 million to $125 million of free cash flow. Overall, the team is doing a fantastic job managing through the challenges of the strong global rebound and deliver a solid glide path to M2022. Now I will turn the call back over to Chris.

Chris Villavarayan, CEO and President

Thanks, Carl. Let's turn to slide 9. While it is difficult to schedule events with certainty, we're planning to hold our Analyst Day in person this year in New York. More details will be provided in the coming months. At that time we will present M2025. We will, of course, closely monitor the situation as we move closer to this date to ensure we can meet safely. Before we close, I would like to express our concern for the serious situation occurring in India as the pandemic worsens. Our team in the region has taken actions to help employees and the community through care centers, vaccination, and mobile testing facilities, and we plan to do more. Our thoughts are with our colleagues and their families during this crisis. Again, I want to thank you for joining us today to review Meritor's second quarter results and welcome any questions you may have at this time.

Operator, Operator

And your first question comes from James Picariello of KeyBanc.

James Picariello, Analyst

Hey, good morning.

Chris Villavarayan, CEO and President

Good morning, James.

James Picariello, Analyst

Just within the company's reiterated guide for the year, you're now anticipating what was I think referred to as record commodity inflation in the back half, right not surprisingly, but can you help quantify what the net headwind exposure is relative to what will likely flow through within your recovery mechanism just to get a sense of that net exposure?

Carl Anderson, Senior Vice President and Chief Financial Officer

Sure. James, it's Carl. As it relates to steel prices, which is the really primary driver for us we do expect it to be year-over-year about $25 million to $30 million headwind in fiscal 2021. So if you think about the recovery mechanisms as that begins to kind of flow through that will come through really beginning in the first part of fiscal 2022. And so of that, we would expect to be recovering around probably $20 million of that number as we go forward.

James Picariello, Analyst

Okay. No, that's really helpful. Just from an industry standpoint focusing on the North American market for a second, I mean again from an industry standpoint we're trying to get near record order levels. This year the industry backlogs are also going to be at or close to all-time highs. Are you seeing anything unique in terms of builds, build commitments, build slot commitments for next year at this point? It just seems as that's where we're going to be especially given the temporary chip shortage impacts which I think are also proving to be more muted. Just seems like we're on track for a really, really strong volume next year.

Chris Villavarayan, CEO and President

For sure, James. I'll take that. So when you think about it, it's beyond the last three months. If you look at it, it's the last six months. Order intake has come in at 40 or above 40. And to your point, backlogs are passing I believe 300,000. And for our fiscal year right now the midpoint with the recent change is 285,000 for the fiscal between ACT and FTR. And if you look at the midpoint for next year for the heavy market, it's at about 340. So to your point, great highs and you got to believe the Texas storms resolved, as well as the fire in Japan. So the chip shortage will get resolved here shortly or will improve shortly. We do believe there is impact through the next couple of quarters, but it eventually should improve. So again, we believe there's a strong 2022 ahead of us as well.

James Picariello, Analyst

Got it. If I could just ask one more question. Regarding the aftermarket and industrial segment this quarter, specifically the second quarter's margins, was there anything related to the timing of price increases or excess premium freight? Any insights on that segment's margins?

Carl Anderson, Senior Vice President and Chief Financial Officer

Yes, James, it was really just driven by a couple of factors. One was, we did see some higher freight costs in the second quarter, as well as a little bit higher cost from steel that affected the aftermarket business.

James Picariello, Analyst

Thanks.

Carl Anderson, Senior Vice President and Chief Financial Officer

Thank you.

Operator, Operator

Our next question comes from the line of Joseph Spak of RBC Capital Markets.

Joseph Spak, Analyst

Thank you. Appreciate it. So I think just to maybe sort of to get a little better sense for some of the costs you talked about, Carl, in the back half, I think, if we look at the guidance it still implies on a year-over-year basis about 20% incrementals. But I think that seems to be maybe some of the base period in the map, because is it fair to assume that sequentially we should see maybe decrementals a little bit higher than normal given some of the headwinds and then as you can start to get some of those recovery mechanisms back next year that reverts?

Carl Anderson, Senior Vice President and Chief Financial Officer

I think that's the right way to think about it, Joe. If you look at the six months EBITDA margin performance to date, we're right around 11.4%. So if you think about what our guide is of 10.6% to 10.8%, that does imply the second half margins will be about 10% on roughly the same type of revenue.

Joseph Spak, Analyst

Thank you for that. I have a broader question regarding electrification. I understand that you've increased spending again. In the past, you've indicated that this spending is aimed at supporting initiatives expected to yield results in the near future. Could you confirm if the additional $5 million to $10 million is intended for that purpose? Additionally, concerning electrification, can you discuss your capability to incorporate other Meritor products, such as disc brakes, alongside eAxle limbs? Is there a significant attachment rate for Meritor products in those scenarios?

Carl Anderson, Senior Vice President and Chief Financial Officer

Absolutely, Joe, but I'll start with the first question. First, I think, glad to see the backlog continuing to grow. As you remember, we talked about having this $500 million target for electrification as our revenue pipeline. We accomplished $400 million of that with the last quarter. And so with this announcement with Hexagon, we've taken a chunk of that. So we continue to see the growth. And to put it in perspective of spend, if you go back to 2019, we spent about $12 million. Last year we spent $21 million, and this year we're moving it up to $35 million to $40 million. So we're almost doubling it per year, and it's primarily because of the wins and it's essentially application and testing of our products as it wins with more customers. To your second question, the ability to attach components, absolutely, we do see a path with brakes with many of the customers as an opportunity to grow business as well.

Joseph Spak, Analyst

But when you up your electrification backlog, I mean, those associated products I am assuming are not in that. So is it fair to assume the other side of your backlog is being benefited too by the electrification wins?

Carl Anderson, Senior Vice President and Chief Financial Officer

It is on, let's call it, everybody that is, let's call it, new entrants coming into the market. So when you think about the new entrants, we have a significant share of the existing traditional business. So it is on the new business, but you also have to take into account when you think about electrification always remember it's five times and up to five times content on a 14Xe, for example. So, we're already seeing that growth as well.

Joseph Spak, Analyst

Okay, Carl, maybe just a quick question about the tax rate and the change in guidance. It seems like you previously indicated a mid-teens rate, so should we now expect something closer to 20% in the later years given the adjustment?

Chris Villavarayan, CEO and President

Well, I think it's, Joe to that point, it's 15% definitely through 2022. I think once you start getting past 2022 you've got to 2023 and 2024; it could begin to moderately step up. So, you're probably not too far off with that assumption.

Joseph Spak, Analyst

Okay. Thanks very much.

Chris Villavarayan, CEO and President

Thank you.

Operator, Operator

Your next question comes from the line of Ryan Brinkman of JPMorgan.

Ben Fung, Analyst

Hi, good morning. This is Ben Fung from JPMorgan for Ryan. I just have two questions. The first one is what is your view on the impact of higher labor cost to margin and production start to come back? And on the same note, how are you seeing freight cost progressing through the rest of the year? I know that someone in the aftermarket last week said something about the freight costs could be two or three times higher than they're seeing right now. So, how much impact to margin do you expect this headwind? And what are some factors that can be used to offset the impact? Thank you.

Chris Villavarayan, CEO and President

Absolutely. Let me begin by addressing the first question about labor. The market is extremely competitive, as you can see. There is a strong demand for our product, which reflects the overall economy, with strong GDP and consumer spending. We have managed to drive some of that recovery with particular customers. Additionally, it is crucial to focus on operational performance, which includes improving efficiency in labor and burden as well as identifying material opportunities. This is how we are achieving savings to mitigate labor costs. Regarding freight, we are experiencing costs that are approximately three times higher, whether it involves ocean freight or internal logistics. We are working to offset these increased costs with improvements in material performance and operational efficiency. Furthermore, we are also collaborating with our customers to navigate these challenges.

Ben Fung, Analyst

And I'm sorry to ask. So, this is pretty cost and everything already factored in the guidance, right?

Carl Anderson, Senior Vice President and Chief Financial Officer

Yes, it is. Yes. And to add to what Chris said, as we look at just overall freight costs in our first quarter, we did experience probably higher premium costs associated with the rapid increase in production that we saw in the first quarter. But what we're seeing is kind of just the basic run rate with costs today is all factored into our guidance.

Ben Fung, Analyst

Thank you. Very helpful. And my second question is on the RV business. So, the RV demand has been very strong in the last few months and just this morning an RV dealer updated their adjusted EBITDA guidance materially. Can you talk about the opportunity for growth in this area of the business? And I think last quarter you mentioned something about independent suspension. With wheels and motors for RVs? And if you can please just give any update on that? Thank you.

Carl Anderson, Senior Vice President and Chief Financial Officer

Absolutely. The industrial specialty and off-highway markets are incredibly important for us, which is why we made the AxleTech and Fabco acquisitions two years ago. We are now seeing the benefits of those acquisitions as we look toward 2022 and assess our revenue pipeline growth. A significant portion of our core business, which we expect to exceed our revenue targets for 2022, is coming from our industrial Defense & Specialty segment. We are experiencing growth in this area. Last quarter, we mentioned that we are developing an independent suspension for this market, which will go into production this year and reach run-rate next year. Additionally, we are working on a similar electric platform to meet needs in the RV space.

Ben Fung, Analyst

Thank you very much for taking my question.

Operator, Operator

The next question comes from the line of Bruce Chan of Stifel.

Matt Milask, Analyst

Hey, good morning. This is Matt Milask on for Bruce Chan.

Chris Villavarayan, CEO and President

Good morning Matt.

Matt Milask, Analyst

Morning. With regards to higher freight costs, you mentioned one of the mitigating things that you're doing is working with customers. Any additional color we can get around there and how those conversations might be going?

Carl Anderson, Senior Vice President and Chief Financial Officer

Sure. At this point, we are collaborating with customers for whom we have agreements in certain regions. As you can imagine, these agreements are complex and take time to finalize. We are actively discussing the details and are already noticing benefits in some areas.

Matt Milask, Analyst

Thanks a lot.

Chris Villavarayan, CEO and President

Thank you.

Operator, Operator

And your next question comes from the line of Itay Michaeli of Citi.

Itay Michaeli, Analyst

Good morning everybody. Just two quick ones for me. First just a little bit of housekeeping on CapEx. I mean, it looks like it's still running maybe below the full year. And I think the original plan for the cumulative CapEx through 2022 was about $475 million. Just curious whether you're seeing efficiency there if that's just some timing?

Carl Anderson, Senior Vice President and Chief Financial Officer

Good morning Itay. It's more timing. For the first six months, we had about $25 million of CapEx. We are planning for about $70 million of CapEx in the last six months of the year. So part of it was production came back pretty quickly as you recall in our first fiscal quarter. And I think some of the programs we are just beginning to ramp back up here this quarter as well as in the fourth quarter for us.

Itay Michaeli, Analyst

That's helpful information. As we consider the transition from the second half margins to the 2022 target, you mentioned some recoveries on steel. Could you please outline some of the significant challenges you're currently facing that will change next year, especially regarding the other steel side?

Chris Villavarayan, CEO and President

The main issue we're facing is related to steel. As I mentioned, the $25 million to $30 million headwind is primarily relevant for the second half of the year. Although freight costs have increased and remain higher than usual, we've managed to offset these costs through improvements in material and operational performance. The key takeaway is that steel is the biggest factor. If we were to account for the $25 million to $30 million impact, our margins would closely align with the margins we observed in the first and second quarters.

Itay Michaeli, Analyst

Got it. Perfect. That’s real helpful. Thanks.

Chris Villavarayan, CEO and President

Thank you.

Operator, Operator

And there are no further questions at this time. And I'll turn the call back over to Todd Chirillo.

Todd Chirillo, Senior Director of Investor Relations

Great. Thank you, and thank you everyone for joining our call today. If you have any questions please feel free to reach out to me directly. Thank you and have a great day.

Operator, Operator

And this concludes today's conference call. Thank you for participating. You may now disconnect.