Oshkosh Corp Q4 FY2022 Earnings Call

Greetings, and welcome to the Oshkosh Corporation Fiscal 2022 Fourth Quarter and Full Year Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Pat Davidson, Senior Vice President of Investor Relations for Oshkosh Corporation. Thank you, sir. You may begin.

Good morning, and thanks for joining us. Earlier today, we published our fourth quarter and full year 2022 results. A copy of the release is available on our website at oshkoshcorp.com. Today's call is being webcast and is accompanied by a slide presentation, which includes a reconciliation of GAAP to non-GAAP financial measures that we will use during this call, and is also available on our website. The audio replay and slide presentation will be available on our website for approximately 12 months. Please refer now to Slide 2 of that presentation. Our remarks that follow, including answers to your questions contain statements that we believe to be forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks that could cause actual results to be materially different from those expressed or implied by such forward-looking statements. These risks include, among others, matters that we have described in our Form 8-K filed with the SEC this morning and other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements, which may not be updated until our next quarterly earnings conference call, if at all. As a reminder, we changed our fiscal year to align with a calendar year effective January 1, 2022. All comparisons during this call to the prior year quarter are to the quarter ended December 31, 2021. All comparisons to the prior year are to the 12 months ended December 31, 2021. Our presenters today include John Pfeifer, President and Chief Executive Officer; and Mike Pack, Executive Vice-President and Chief Financial Officer. Please turn to Slide 3 and I'll turn it over to you, John.

Thank you, Pat, and good morning, everyone. We delivered strong earnings growth in the quarter, both sequentially and compared with the prior year. For the quarter, we reported revenue of $2.2 billion, highlighted by year-over-year sales growth in all four segments, leading to adjusted earnings per share of $1.60. Strong sequential improvement over adjusted EPS of $1.12 in the third quarter and even stronger improvement over the prior year quarter. Importantly, we delivered another quarter with a double-digit operating income margin in Access Equipment of 10.8%, which is a record margin for the fourth calendar quarter. Demand remains solid and we finished 2022 with strong orders and a record consolidated backlog of more than $14 billion. We are continuing to prudently invest in capacity in all of our segments to take advantage of long-term demand trends. We also continue to invest in exciting new products, including our growing stable of purpose-built electric vehicles that we expect will charge future growth. Our EPS results for the quarter were lower than our expectations of approximately $1.86 caused by two factors. First, the mix of aftermarket parts in our December JLTV order in the defense segment was less favorable than our expectations. And second, Access Equipment deliveries, while strong, were lower than planned. We have several important highlights during the quarter. In November, we announced an agreement to acquire Hinowa S.p.A., an Italian manufacturer of compact crawler booms, as well as other tracked equipment and a long-time partner of JLG. I'm proud to announce that we are closing on this acquisition today. Hinowa brings innovation leadership with lithium-ion powered equipment that supports our expansion into adjacent markets. We believe this acquisition is an outstanding growth platform and provides expanded manufacturing capabilities in Europe. Hinowa represents another attractive bolt-on acquisition in line with our disciplined approach to M&A that supports our commitment to grow shareholder value. Additionally, we were once again recognized for our strong sustainability practices by being named to the Dow Jones Sustainability World Index for the fourth consecutive year. We were also named one of America's Most Responsible Companies by Newsweek, a recognition of our commitment to our core values and excellent corporate citizenship. Please turn to Slide 4 for a recap of 2022. We grew revenues by just over 4% in 2022 compared to the prior year, delivering adjusted EPS of $3.46. Adjusted EPS was lower than the prior year, largely due to manufacturing inefficiencies associated with supply chain disruptions and unfavorable price/cost dynamics, including unfavorable cumulative catch-up adjustments in our Defense segment. Our teams have made significant progress combating inflationary pressure by implementing multiple price increases over the past year and persevering through supply chain disruptions. These actions enabled us to more than triple our adjusted operating income from the first half to the second half of the year, providing us with important momentum as we expect to significantly grow revenue and earnings over the next few years. Our outlook remains consistent with our Investor Day presentation based on strong market drivers and our innovative products, including USPS Next Generation Delivery Vehicle and electrified products including the Volterra line of electric fire trucks, as well as our pioneering DaVinci all-electric scissor lifts. We believe these products will be important drivers of growth as we move toward 2025 and beyond. In addition to Hinowa, we also acquired or invested in other businesses during 2022 that will facilitate growth in the new product categories and adjacencies. These include CartSeeker with its patented AI-based recognition technology used on refuse collection vehicles, Robotic Research, a global leader in autonomous mobility and Maxi-Metal, a Canadian leader in fire truck manufacturing headquartered in Quebec. As we look to 2023, we expect the continued execution of our innovate, serve, advance, growth strategy, price cost management and strong tailwinds supporting our business will allow us to drive significant improvement in our earnings compared with 2022. We are initiating 2023 earnings per share guidance in the range of $5.50. While demand remains very robust, we expect that supply chains will continue to constrain revenue during the year. Mike will provide more details in his section. Finally, we are pleased to announce an increase of $0.04 or 10.8% to our quarterly dividend rate today. This is the ninth consecutive year that we have announced a double-digit increase to our cash dividend. Before we talk about our segments in more detail, I wanted to discuss an exciting change to our business segments. Please turn to Slide 5. This morning, we are forming a new Oshkosh Corporation segment called Vocational. We are combining our Fire & Emergency and Commercial businesses, which all design, develop and manufacture purpose-built vocational vehicles for people in our communities who do tough work. By combining these businesses, we expect to drive enhanced efficiencies across the board while better leveraging our scale and technology development at an accelerated pace. We believe the Vocational segment will also serve as a platform for further organic and inorganic growth opportunities in several important end markets. We expect that the Vocational segment will initially be a $2 billion plus revenue segment with the opportunity to grow organically at a high-single digit compound annual growth rate to near $3 billion with 12% plus operating margins in the next few years. We are also announcing that we've entered into a definitive agreement to divest our rear discharge concrete mixer business. We expect to complete the sale by the end of the first quarter. This will enable us to focus on attractive end markets that value technology and innovation and will drive higher margins over time in our new Vocational segment. Going forward from today, our businesses will be aligned in three segments: Access, Defense and Vocational. The Vocational segment will be led by our current Fire & Emergency segment President, Jim Johnson. Jim and his team have successfully transformed the performance of the Fire & Emergency segment over the past decade, and I am excited for our talented teams in both segments to come together as a force multiplier for the future success of the Vocational segment. We look forward to sharing more details in the coming quarters. Please turn to Slide 6 and we'll get started on our segment updates with Access Equipment. Our Access team delivered solid performance in the fourth quarter with a double-digit operating income margin and 620 basis point year-over-year margin improvement. Supply chain challenges limited our production output, but we have seen some improvements, particularly in December as supplier on-time delivery metrics climbed above 70% for the first time in several months. While this is still well below our historical level of 90% plus on-time delivery, it represents improvement. The team at Access made progress by qualifying additional suppliers, dual sourcing and leveraging alternate sourcing strategies. The team resourced more than $270 million of parts in the past year with plans to do more in 2023 to further improve supply chain performance. We also continue to implement changes to our products and processes to improve both output and manufacturing efficiencies. Demand remains very strong for our market leading JLG products driven by strong utilization rates, elevated fleet ages and the large number of mega projects underway across the United States. In fact, the percentage of Access Equipment in rental fleets deployed in the mega projects, which are generally defined as projects with a value of $400 million or more has more than doubled over historical levels. We expect that mega projects, including factories for EVs, batteries and chips as well as non-residential projects such as data centers and healthcare facilities will continue to contribute to strong demand for our equipment for the foreseeable future. We ended the quarter with a record backlog of nearly $4.4 billion. Fourth quarter orders were strong once again at $1.55 billion, and we continue to have visibility to demand well beyond our current backlog. Please turn to Slide 7 and I'll review our Defense segment. The Defense segment continues to engage in a significant number of new business opportunities, as well as current programs. During the quarter, we received two separate contract awards for JLTV I, valued at a total of $645 million. The first award was for domestic requirements, while the second included several hundred units of foreign military sales, many of which will be bolstering the tactical wheeled vehicle fleets of Eastern European nations. The DoD's announcement date for the JLTV II contract has been pushed back from late January, and we expect an award decision this quarter. The JLTV has been a foundational product for our Defense segment, and we are confident that we can deliver even more value to our customer in the future. In December, our Defense team was selected to produce Eitan Armored Personnel Carrier hulls for the Israeli Ministry of Defense under a contract expected to be valued at over $100 million. This is another key adjacent program win for our team similar to the Stryker MCWS and NGDV programs that demonstrate the success of our offerings and programs beyond tactical wheeled vehicles. I'll close out my comments on our Defense segment with an exciting update on our progress with the USPS's NGDV program, which allows for delivery of up to 165,000 vehicles over the 10-year duration of the program. In late December, both the USPS and President Biden made important announcements that express the Postal Service's intention to increase the number of units in the initial order from 50,000 to 60,000 units and increase the percentage of battery electric vehicles to approximately 75%. This change will enable the USPS to electrify their fleet at a faster pace. We are actively engaged with our customer to formalize the contract modifications to reflect the change. This is great news for the USPS, communities across our country and our company. We believe we are well positioned to supply the increased percentage of BEV units and continue to expect a significant ramp-up of production in 2024 and 2025. Let's turn to Slide 8 for a discussion of the Fire & Emergency segment. Our Fire & Emergency segment made progress to improve output as indicated by fourth quarter sales that were up approximately 21% sequentially and approximately 37% versus the prior year quarter. While production output remains constrained by current supply chain dynamics, the improvement in production outputs and deliveries is encouraging. The improvement was driven by higher supplier on-time delivery metrics as well as the benefit of operational improvement initiatives. Our operating margins remain below typical levels for Fire & Emergency due primarily to supply chain impacts on production as well as the time lag in realizing the benefits of our significant price increases with municipal customers. We remain confident that we will return to strong double-digit margins as production output increases and we realize a greater portion of the price increases we have implemented. Demand for municipal fire trucks has remained very high bolstered by aging fleets and solid municipal budgets. Order rates have remained strong, leading to a record $2.9 billion backlog, which provides us with good visibility and supports our outlook for higher margins over the next two plus years. Our lead times have extended beyond our optimal timeframes. But we believe the actions we're taking to improve parts supply as well as our capacity expansions, including robotic painting in Appleton will help us increase output as we move through 2023 and into 2024. I had the opportunity to participate in our Pierce Annual Dealer Meeting this past month. I continue to be extremely impressed and inspired by our dealers. They are continuing to make significant investments in parts and service capacity to support our customers and drive growth. We believe these investments are critical to our long-term success as the population of Pierce fire trucks in the field continues to grow. Please turn to Slide 9 and we'll discuss our Commercial segment. Commercial sales increased by 34% to nearly $283 million versus the prior year, despite persistent third-party chassis and component constraints limiting production. We expect that chassis and other materials will remain a significant constraint in 2023 as well. We've previously highlighted the success we're having with our first refuse collection vehicle automated high flow line in Dodge Center. We are beginning to work on our second high flow line, which is expected to go live in the second half of 2023. Our high flow lines leverage integrated automation to drive improved quality, shorter build cycle times, lower direct labor hours and increased manufacturing efficiencies, all of which are expected to drive higher operating margins. As we previously discussed, we see significant opportunities in electrification, automation and other advanced technologies, particularly in the RCV space. We expect to continue to make meaningful investments in new products and manufacturing facilities over the next several years. We look forward to sharing more details over time. With that, I'm going to turn it over to Mike to discuss our results in more detail and our expectations for 2023.

Thanks, John. Please turn to Slide 10. Consolidated sales for the fourth quarter were $2.2 billion, an increase of $412 million or 23% over the prior year quarter. All segments contributed to the sales increase, led by Access Equipment, which was up by $241 million, or 29% versus the prior year. The consolidated sales increase was driven by increased sales volume and higher pricing to offset the impacts of inflation, particularly at Access Equipment. Fourth quarter consolidated sales were approximately $70 million lower than our most recent expectations, largely driven by lower volume at Access Equipment. Moving to adjusted operating income, we implemented an inventory accounting method change in the fourth quarter, moving the approximately 80% of our inventory that had been valued at LIFO to FIFO. The FIFO method of inventory valuation results in better matching of revenues with expenses since it more accurately reflects the current value and physical flow of inventory. FIFO also aligns our inventory valuation methodology with the majority of our peers and results in a consistent inventory valuation method throughout Oshkosh. Current and prior year adjusted operating income amounts have been restated on a FIFO basis. Adjusted operating income increased $111 million over the prior year quarter to $153 million, or 6.9% of sales, representing a 460 basis point improvement versus the prior year. The improvement in adjusted operating income versus the prior year was largely driven by improved price cost dynamics and increased volume versus the prior year, particularly at Access Equipment, partially offset by production inefficiencies. Adjusted earnings per share was $1.60 in the fourth quarter versus $0.36 in the prior year. Our adjusted earnings per share was lower than our most recent expectations as a result of lower volume at Access Equipment and a less favorable mix of aftermarket parts in our December JLTV order. Now let's turn to our outlook for 2023. Please turn to Slide 11. We're estimating consolidated sales and operating income will be in the range of $8.4 billion and $530 million, respectively. We are estimating EPS will improve to be in the range of $5.50, representing significant growth versus adjusted EPS of $3.46 in 2022. Included in our expectations is the EPS impact of approximately $0.80 related to incentive compensation costs returning to typical levels and increased new product development investments of approximately $0.30. Demand remains strong as indicated by order intake of $3.3 billion in the fourth quarter, leading to our record backlog of over $14 billion on December 31, 2022. Our guidance reflects modest supply chain improvements in 2023, but we expect that supply chain impacts will continue to limit our revenues and contribute to production inefficiencies during the year. At a segment level, we are estimating Access sales and operating margin to be in the range of $4.2 billion and 11%, respectively. The expected 300 basis point improvement in operating margin versus 2022 is driven by the full year benefit of improved pricing and a modest volume increase. We expect supply chain dynamics to remain a limiting factor for more significant revenue growth as demand remains very robust. Turning to Defense. We are estimating 2023 sales of approximately $2 billion, or roughly $140 million lower than 2022. As previously discussed, we anticipated that revenues would be down in both 2022 and 2023. Importantly, we expect that revenues will begin to grow in 2024 as the USPS NGDV production begins to ramp up. We're estimating our defense operating margin will be approximately 4%. We expect lower sales, unfavorable product and aftermarket mix and NGDV related pre-production operating expenses to account for the mid-single-digit operating margin. We also expect margins will improve as new programs ramp up in 2024 and beyond. Moving to our new Vocational segment. Our guidance includes the combination of our former Fire & Emergency and Commercial segments and reflects the planned divestiture of our Rear Discharge Concrete Mixer business during the first quarter of 2023. We expect Vocational sales will be in the range of $2.2 billion, which is roughly flat to the combined revenue of the Fire & Emergency and Commercial segments in 2022 despite the approximately $150 million sales impact of our planned divestiture of our rear discharge mixers. Similar to Access, demand remains very strong, but our revenue is expected to be constrained in 2023 by supply chain dynamics. We expect the operating margin in the Vocational segment will be approximately 7.5%, reflecting the impact of constrained output manufacturing inefficiencies due to supply chain dynamics, the impact of price protected orders and higher new product development investments. Municipal customer orders in our backlog to be delivered in 2024 were booked with significantly higher prices and we expect them to drive meaningfully improved margins in the future. We also expect margin benefits over time from the integration of our two segments into Vocational. We estimate corporate expenses will be approximately $170 million versus $141 million in 2022 driven by a return of incentive compensation to typical levels and increased investments in growth initiatives and new product development. We estimate the tax rate for 2023 will be approximately 25% and we are estimating an average share count of 65.7 million shares. For the full year, we are estimating free cash flow of approximately $300 million, which is impacted by a higher than typical capital expenditures of approximately $350 million as we complete the NGDV facility in South Carolina and invest in manufacturing capacity as well as new product development initiatives throughout the company. Recall that organic investment is a top capital allocation priority for us. Looking to the first quarter, we expect consolidated sales to be in the range of $2.1 billion, down approximately $100 million versus the fourth quarter. We expect lower revenues compared to Q4 2022 will be driven by the timing of deliveries in our Access and Vocational segment as well as lower sales at Defense. We expect EPS will be around $1, reflecting lower sales, unfavorable order mix in the Defense segment and the return of incentive compensation costs to typical levels when compared to the fourth quarter of 2022. We expect that the first quarter will be the lowest quarter of the year for EPS based on these factors. I'll turn it back over to John now for some closing comments.

We delivered significant sequential improvement in earnings and strong overall performance in the quarter. We are also making investments that will drive future growth, supply chain dynamics remain our most significant challenge and we are taking actions to drive higher output over time. We believe the fundamentals in our end markets remain very strong and we expect to deliver robust earnings growth in 2023. Okay, Pat, back to you.

Thanks, John. Excuse me, I would like to remind everyone to please limit your questions to one plus a follow-up and please stay disciplined on that follow-up. Afterwards, after your follow-up, we ask that you get back in queue if you'd like to ask additional questions. Operator, please begin the question-and-answer period of this call.

Thank you. We will now be conducting a question-and-answer session. Thank you. Our first question comes from the line of Nicole DeBlase with Deutsche Bank. Please proceed with your question.

Yeah. Thanks. Good morning, guys.

Good morning, Nicole.

If you could just start with the outlook for Access. So I think the revenue guide implies kind of like 6% full year growth. Can you just talk about what you're embedding for price versus volume and maybe how that relates to what you're hearing from your rental customers going into the year?

Sure. I guess from a revenue guide perspective, I think foundationally, there's limited volume increase. A lot of it is just benefiting from the full year of run rate. We did implement an additional price increase of 3.5% on the first of the year, that's incremental to where we were in the fourth quarter. So right now, again, obviously, we have very, very robust demand right now. Supply chain is really the constraining factor from revenue being higher. So that's really what we're going to be continuing to watch over the course of the year is what transpires with supply chains.

Yeah. And I'll just emphasize that, Nicole. Our revenue and Access is not constrained by the order rate. We've got really strong dynamics in the market. You saw the healthy backlog continuing to grow really strong orders, it's entirely supply chain driven in terms of how much we can produce and ship in 2023.

I appreciate that information. Thank you. Now shifting to Defense, I was somewhat surprised by the 4% margin outlook for 2023. It seems mainly influenced by the mix. What is the expected timeline or likelihood for this segment to return to a more typical high-single digit margin? Thank you.

Our expectation is that the lower volume we experienced last year, combined with this year’s mix, is creating challenges. We have also been impacted by inflation. Looking ahead to 2024, as the Postal Service and other significant programs ramp up, we anticipate margins will start to return to more typical levels, supported by increased volume. Additionally, there is still about a 1% drag in 2023, similar to last year, related to NGDV selling, general, and administrative expenses that are not capitalized before the program begins. We expect to see a decline this year, but we anticipate growth moving forward. Furthermore, as we look at new programs with economic price adjustments, particularly for initiatives like JLTV II, those should provide better protection against inflation over time.

Thank you. I’ll pass it on.

Thanks, Nicole.

Our next question comes from the line of Mike Shlisky with D.A. Davidson. Please proceed with your question.

Yes. Hello. Good morning and thanks for taking my questions. John, one of your comments about Access were about the U.S. market. I was wondering, if you can update us on how conditions are internationally for Access going into 2023?

International positions at Access have been relatively healthy, especially when you adjust for constant currency, currencies hurt us a little bit with the strong dollar. But if you adjust for constant currency, the European market is for us or our business in Europe, I should say, is up nicely. We're up really strong in Latin America. I think the one outlier there is, of course, China. China is a huge market for the Access Equipment business, and we all know what's going on in China, starting with the COVID lockdowns and how that's really hindered the economy in China. So Asia-Pacific in total has been down year-over-year. Now some nice pockets of growth in there, but China kind of being down, pulls the whole region down. We still do expect China to be over longer periods of time, a nice growth market. So this is likely a shorter-term phenomenon where we've seen China come down so sharply. But I would say, outside of China, it's been maybe even better than expected around the world in terms of conditions and our ability to generate revenue.

Great. Thanks. And then just turning to Vocational. You had mentioned wanted to grow this from $2 billion to $3 billion over the next couple of years. I'm just trying to get a sense as to why combine these two. Do you have plans to enter other locations over the next couple of years or is it going to be strictly fire, waste and whatever that of concrete going forward? Just some feel for what the mix might look like in a couple of years?

We are very optimistic about establishing a Vocational segment, which will significantly benefit our operations. The businesses within the Vocational market focus on purpose-built vehicles that enhance productivity and safety for specific end markets. This includes products like fire trucks and refuse or recycling collection vehicles. By streamlining our business in this way, we anticipate achieving operational efficiencies in both overhead and production. More importantly, we will utilize our scale to accelerate technology development. We've made progress with electric fire trucks and autonomous features, and we believe we can expand these efforts quickly to foster organic business growth. We aim to reach $3 billion in revenue within our planning horizon, and with potential inorganic opportunities, we could surpass that figure. This represents an exciting growth opportunity for our company as we expect to see significant margin improvement alongside revenue growth.

Okay. Thanks. I’ll pass it along.

Our next question comes from the line of Chad Dillard with Bernstein. Please proceed with your question. Chad Dillard, your line is live.

Hi. Good morning, guys. So I was hoping you guys could talk a little bit more about your expectations for price cost cadence as well as just manufacturing absorption as you think about first half versus second half of this year?

From a price cost perspective, the second half of 2022 serves as a solid reference point because we were largely neutral in that period, and this trend continues into next year. We have made additional price increases. Specifically, with the recent increase at Access, we are in a neutral to positive position, and our historic commercial business reflects similar conditions. However, we have a longer adjustment period with our municipal customers and in Fire & Emergency due to bonded orders, which means we face challenges with inflation in 2023. Looking ahead to 2024, we have a robust backlog with considerable price increases, potentially in the double digits compared to our current position. We anticipate returning to normal margins in 2024. Overall, we expect the company to remain price cost neutral to positive for the entire year, measured against the start of inflation in 2021. In the first half of the year, we will likely see quarter-over-quarter benefits similar to those experienced in the latter half of 2022.

That's super helpful. And the second question is just on Access. Clearly, you have a pretty strong backlog in that segment. So how far out do your build slots go? Like, what share of the backlog is getting shipped in '24? And I know there are some supply chain constraints, but let's just assume that they lift. So what extent do you have appetite to add further shifts to drive further production this year?

In the Access business, we have a $4.4 billion backlog as we head into 2024 based on our current capacity. Our capacity is limited mainly by supply chain issues, but we anticipate improvements throughout the year. We are implementing strategies such as dual sourcing, resourcing, and utilizing analytics to anticipate potential problems, all of which are contributing to the positive changes we've observed. Additionally, we have approximately $1 billion in unentered orders and recently booked $1.5 billion in orders this quarter. This indicates a robust business with strong long-term dynamics. We are also looking to expand our capacity since it is essential for our operations. As we resolve supply chain challenges, we will not only need to add more shifts but also enhance our facility capacity to facilitate quicker deliveries.

Thank you.

Thanks, Chad.

Our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.

Yes. Hi. Good morning, everyone. John, I wonder if you could just go back to the Access Equipment outlook for a second. So essentially, up 6%, given the price increases implies volumes that are down and your customers are looking for CapEx to be up this year on a unit basis. And so I know you're not in the business of doing any market share? Is it just a function of, hey, look, it was a tough supply chain year last year, so let's make sure we're in a position to hit our guidance or are there other moving pieces that are specifically impacting any particular components that are still very hard for you folks in this business?

We are trying to be realistic given the past six quarters of significant supply chain disruptions. We've made considerable efforts that are beginning to show some results, but we want to set realistic expectations for our customers based on what we've experienced. We don’t anticipate an immediate fix where everything suddenly returns to normal. We are planning to add capacity to improve our delivery times, but we need to do this carefully since simply increasing capacity will not solve supply chain issues. We must work closely with our suppliers to enhance the supply chain. That's the best way to explain our approach.

Super. And relative to your guidance if Access volumes do surprise to the upside, if we're able to deliver on the supply chain. Is it fair to expect 25% to 30% incremental profitability on any incremental volumes, if we are able to ramp deliveries?

I would generally estimate incrementals in the low-20s. As we increase volume, pricing will likely support typical incrementals, but we are still facing some challenges from manufacturing efficiency that are holding us back. Therefore, I would anticipate these incrementals to be slightly below normal. Nonetheless, as volume goes up, we should see some of these efficiency issues begin to improve.

All right. Super. Thanks.

Our next question comes from the line of Stephen Volkmann with Jefferies. Please proceed with your question.

Hi. Good morning, everybody. I want to go back to Defense, but more on the USPS side, so that contract has changed quite a bit since we first started looking at it, obviously, more volume and more mix of battery. I assume that makes a pretty significant difference in kind of the cost per unit, which obviously means you're going to get more revenue as we go forward. Please disagree if you want to. But I'm also trying to think about, are these BEV margins sort of the same as ICE or would those also be higher? And then sorry, I'm throwing a lot at you, but does it also mean that there's going to be higher R&D and development and startup costs than we might have otherwise assumed.

The move towards 75% battery electric vehicles (BEV) by 2026 is a positive development for the USPS and communities across the country that want more electric options. While the price of BEVs is higher than that of internal combustion vehicles due to increased costs, the margin percentages are similar, although the total margin dollars are higher. The overall investment isn't expected to change significantly, but the timing might shift slightly since the initial order began with 10% BEV and has now increased to 75%. Any timing changes are not anticipated to be material. We expect to begin production in 2024 and aim to reach full production in 2025, as indicated in previous calls. This program is positive news for everyone involved.

Okay. Great. And just as a follow-up, do you have BEV units currently out on the road for testing? I assume you must if it's going to start...

We've got prototypes and validation units and so forth.

And do you get involved in charging at all or is that somebody else?

Well, we want to be a total solutions provider to our customers. It doesn't matter if it's the United States Postal Service, a municipal fire station, we intend to be a total solutions provider. So we're there to support the U.S. Postal Service in any way that they want us to provide support, and that's what we'll do. But it's ultimately up to the U.S. Postal Service as to exactly how they want to execute the recharging part of it.

Thank you so much.

Thanks, Steve.

Our next question comes from the line of Jamie Cook with Credit Suisse. Please proceed with your question.

Hi. Good morning. I just wanted to dig into the Vocational margin guide. It was even understanding we're combining Commercial and Fire & Emergency, but it's lower, I guess, than I would have thought, not really much of a year-over-year improvement. So can you talk to the path to get to, I guess, F&E margins would be the driver there to double-digit? And then, John, just given where the guidance is today, can you talk about your comfort level with your 2025 financial targets or should we assume that just gets perhaps pushed to the right? Thanks.

Sure. I'll start with Vocational. The way to think about it is that combining the two segments suggests modest growth, but you need to account for $150 million to $200 million typically associated with Rear Discharge Mix Service, which adds some noise to the picture. This year, we also have a transition services agreement, meaning we won't fully capitalize on the cost synergies yet. That's something we will keep an eye on for the future. The main factor affecting our margins, as both John and I noted in our prepared remarks, is that the typical margins for Fire & Emergency, especially in municipal fire trucks, are currently lower due to manufacturing inefficiencies and a challenging supply chain environment. However, we expect that as we enter 2023, more price increases aligned with inflation will come into effect, along with significant double-digit increases already in backlog beyond current levels as we progress into 2024. As supply chains normalize and we realize those pricing benefits, we anticipate returning to our typical margins in 2024 and beyond.

Let me address your question about 2025. We provided our outlook for that year back in May, and we still view it as achievable. To break it down a bit, our backlog continues to grow, now exceeding $14 billion. This growth is due to our effective new program designs and successful contract wins in the Defense sector, which we’re enthusiastic about. Strong order rates and backlogs are encouraging signs. We're developing exciting new programs in areas like electrification and autonomy, which we see as key to our future and the growth of our backlog. The short-term challenges we face include dealing with inflation and supply chain disruptions. We've made significant progress addressing inflation, and we expect the situation to improve further. Similarly, as we execute improvements in our supply chain, we anticipate positive changes there as well. Overall, looking at the long-term prospects of our business, the contracts we're securing, and the programs in development, we are confident that reaching $25 is achievable.

Thanks, Jamie.

Our next question comes from the line of Mig Dobre with Baird. Please proceed with your question.

Hey. Thanks. Good morning, guys. Maybe sticking with the USPS contract. How much revenue, if any, is embedded in your 2023 outlook? And my recollection is that in your 2025 targets, you had something around $700 million worth of revenue associated with this contract. So I guess the question is, based on all the changes that have occurred since you issued those targets, is that still a reasonable number and can you give us some perspective as to how we're going to ramp in '24 to get to that 25% figure.

Sure. The revenue and margin from NGDVs this year is quite minimal, as we've indicated. Production will begin later this year, so it won’t be a significant contributor until 2024, with full-scale production expected in 2025. As mentioned earlier, considering the shift in mix, we anticipate some revenue growth. The quantities we are projecting for 2025 are not substantially different from what we discussed during Analyst Day.

But the mix could be up.

Absolutely.

Right. And I don't know if this is going to ramp linearly or if there's some kind of a more back-weighted sort of mechanism that you guys are anticipating right now?

Well, I think the U.S. Postal Service wants us to get to full rate production as fast as we can.

Great. Okay. Then my follow-up, going back to Vocational. I appreciate what you're trying to do here combining all these business lines, but it sounds to me like your ambitions are obviously a little bit greater than the product lines that you currently have. Is there some thought here that you can lean a little more aggressively into M&A, and maybe really add some new verticals here in the next couple of years?

We believe in expanding our business through technology, particularly with products like the Volterra electric fire truck, which will serve as a growth platform for years to come. We're also viewing this as a promising opportunity for mergers and acquisitions. Our focus is on creating purpose-built vocational products, meaning we design and develop the entire vehicle from scratch to meet specific market needs. We see potential for growth in this area and recognize that there will be opportunities for inorganic growth. While it’s challenging to predict the timing of these opportunities, we aim to extend our segment beyond our current organic reach. However, we are confident in our current organic position, expecting it to reach $3 billion even without any M&A.

Okay. Appreciate it.

Our next question comes from the line of Tami Zakaria with JPMorgan. Please proceed with your question.

Hi. Good morning. Thank you so much. I have a couple of quick questions for you. So the first one is, can you comment on the margin profile of the Rear Discharge Concrete Mixer business that you're exiting; I think you mentioned about $150 million in sales, but I didn't catch the margin profile of that business.

Tami, it's very low-single digits.

Got it. And the $0.30 new product development investment headwind this year, should we think about that completely reversing in 2024 or should that stay in the base for the next couple of years, but then it kind of reverses? So how should we think about that?

Hey, Tami. I think if you think about what we talked about at Analyst Day, I would expect that we continue to have strong investments over the next few years. So I think that would be representative of over the next few years.

Got it. Can I squeeze in one last one. Can you provide some quantification on the cost synergies you expect by combining the F&E and Commercial segments?

Yeah. We're not providing quantification yet because, particularly this year, with the transition services agreement, there's going to be a bit of a delay over the next several months and being able to act up on those. But we do expect them over time. And certainly, we'll provide updates as we go.

Thank you so much.

Our next question comes from the line of Stanley Elliott with Stifel. Please proceed with your question.

Hey. Good morning, everyone. Thank you all for taking the question. A quick question on the new Vocational group with the waste collection vehicles and then also with the fire vehicles. How aggressive do you see those end markets moving to pursue more of an EV sort of, or battery electric vehicle offering that you guys have been testing in the marketplace currently?

It depends on the end market, but let's consider the Volterra electric municipal fire truck and the Volterra airport rescue and firefighting vehicle. We plan to release these for sale and start production in 2024. When we mention units going to Portland, Oregon, Madison, Wisconsin, and a few other locations, these are essentially beta test units. There are municipalities eager to partner in the development, and that process is going very well. The interest we are receiving from municipalities across the country is exceptionally strong, although there are some regional variations. For instance, California is likely to lead in terms of demand for this product due to its commitment to electrification at a faster pace than other areas. However, interest is not limited to California; we are seeing significant interest from dealers all over the country. This is expected to be a solid long-term growth product. In other end markets where we operate, the uptake could even be faster. This enthusiasm is one of the reasons we are so optimistic about this new segment.

Great guys. That's it for me. Thank you.

Our next question comes from the line of Seth Weber with Wells Fargo. Please proceed with your question.

Hey, guys. Good morning. I apologies if I missed this, but I wanted to better understand the Access margin guidance for this year. If you guys are going to be doing $4.2 billion of revenue, and it sounds like price cost is neutral to positive. Your 11% margin is below what you guys did in 2019 or it's about on par with what you did in 2018 at lower revenue. So I'm just trying to understand what's changed here and why margins aren't better with the higher revenue? Thanks.

Sure. It's really two things, Seth. Number one, obviously, we talked about price cost that I would say that because of the supply chain environment, the impact on manufacturing is still significant. So we're seeing much higher manufacturing inefficiencies than we would have seen in those previous periods, which as supply chains normalize, that will improve. And again, even though the volumes lower from a throughput perspective, there's fewer units. So that obviously has a bit of an absorption impact as well that sort of plays into that. So I think that's really probably the biggest thing.

Okay. But it's fair to say that your price cost neutral to positive for 2023 and Access sounds good.

Yeah. When you're looking at input costs, correct.

All right. Okay. And then just on…

What I would say is, with new product development, especially in our access equipment segment, we see a significant factor there. As volume increases, our perspective remains the same; as volume rises and we benefit from absorption and manufacturing efficiencies, we expect margins to improve over time.

Regarding free cash flow, is the capital expenditures increase in 2023 to $350 a one-time spike, or do you anticipate that it will remain at this elevated level for the next few years as you implement your plans for additional capacity?

Yeah. I think if you go back even to Analyst Day, we expected that this past year and then in 2022 and 2023, it would be pretty robust. We're really looking at through 2025, averaging about $250 million of CapEx, that's still our view. So I think we'll continue to run probably a little bit higher. I don't know that it's necessarily going to be at the same level it is this year. I think this year, with a number of programs sort of converging. It's probably our peak year.

Okay. That’s super helpful. Thank you.

Thanks, Seth.

Our next question comes from the line of Dillon Cumming with Morgan Stanley. Please proceed with your question.

Great. Good morning, guys. Thanks for the question. Just wanted to ask a longer-term one on Access first. I feel like it's been pretty clear that a lot of the rental companies still will not be able to make a dent in their fleet age this year. And just given your commentary around non-res construction, it still feels like you have multiple years of visibility there too as well. Just from our perspective, most of the consensus are still not giving you credit for the longer-term sales targets that you put out there at the Investor Day. Can you speak to kind of any multi-year visibility that you still have been in access that can actually maybe kind of give us confidence in actually hitting those targets over the long term?

First of all, I want to stress that we feel confident about the factors driving demand in the Access marketplace. Our equipment is primarily influenced by non-residential and industrial spending. It's important to highlight that slower residential metrics are not affecting non-residential demand. We are observing a clear distinction between these two areas, and our major customers are reporting the same trends. Currently, we are experiencing unusual conditions, with aging fleets and numerous mega projects fueled by significant government spending, such as the CHIPS Act, that are boosting demand for these large-scale projects that will continue for an extended period. As I mentioned earlier, many fleets are being utilized in these mega projects, and many have not yet begun operations. Our customers are primarily increasing their fleets in response to equipment demand rather than replacing them. However, it's crucial to remember that they will eventually need to replace their fleets, which adds another layer to the factors driving demand. These elements are the main reasons we anticipate a multi-year continuation of demand in this segment.

Got it. Thanks, John. If I just ask a follow-up then on the bus mix and the USPS contract again. Can you just speak to kind of the overall maturity of the supply chain, how that's developed over the last year or so? You've still been working with Microvast, but just kind of their own ability to handle your own ability to handle in terms of sourcing those components getting that battery supply chain kind of up and kind of ready to actually supply those higher volumes that you're expecting over time?

Yeah. Well, I think the thing that we pay most attention to is the new components that get supplied to us and i.e., that means the BEV-type components, like, the lithium-ion batteries. And we feel really good about our supply chain for lithium-ion batteries as one example. And we pay attention to it right down to the cell and where the cell is coming from. And we will continue to pay attention to it because as we all know, there's a lot of demand on lithium-ion battery supply today, and it will continue to grow as we see the automotive industry and other industries like ours continue to electrify. So we'll continue to pay very close attention to it. We also have contingency plans for the current path that we have. But we feel good about it. In terms of e-drives and other systems that go into a BEV, they're household name companies that are our partners. And we'll continue to pay very close attention to it. With every day that goes by, we'll get into production over the next year, and we feel good about where the program is.

Great. Thank you.

Our next question comes from the line of Steven Fisher with UBS. Please proceed with your question.

Hi. Thanks. Good morning. Just wanted to ask about the cadence of the Access margins in 2023. It sounds like you expect lower Access revenues in Q1. So I think that should imply lower margins. And then just higher margins than exiting the year relative to that full year 11%. So I guess I'm curious if you agree with that. And then to follow up on Jamie's question, how that exit rate margin in access in 2023 might relate to your 12.5% to 13.5% on 2025 margins. It seems like if we're going to be above that 11% exiting this year, you should be getting pretty close to that long-term margin range before 2025.

Sure. To start with your last question, regarding the exit rate, I believe that in the first quarter, our margins across all businesses will generally be lower. I mentioned in my prepared remarks that we are experiencing a mix issue with an order in Defense that is impacting the margin negatively. Additionally, in Q1, revenues in Access and Vocational are down due to the timing of deliveries rather than production issues, which will further affect margins. We anticipate that this will be the lowest margin of the year, with improvements expected as the year progresses. Concerning Access margins, the reason they are currently lower than in 2019 is that our unit volumes remain down, leading to unfavorable absorption and current manufacturing inefficiencies. Therefore, these margin challenges are closely tied to supply chain issues. As unit volume increases, the margins we are discussing for 2025 are definitely achievable, so the focus should be on supply chain dynamics.

Okay. And then did you comment at all about how you're thinking about catch-up adjustment potential in Defense in 2023, assuming there might be more inflation, what's your expectation for catch-up adjustments this year?

Our expectation is that we have them every quarter, and we're incorporating everything we know. We certainly don't expect inflation to be lower this year, and that is reflected in our estimates. I think what to watch regarding the cumulative catch-up adjustments is the pace of inflation, given the significant variability over the past year. Inflation was much higher than expected 18 months ago. Even though inflation is elevated now, it doesn't seem to be increasing at the same rate, which leads to estimation challenges. Therefore, despite higher inflation, we believe there will be less volatility moving forward.

Makes sense. Thanks a lot.

Our final question comes from the line of Michael Feniger with Bank of America. Please proceed with your question.

Hey, guys. Thanks for squeezing me in. Apologies if this was asked earlier, just how should we view the continuing resolution headlines with the Defense and Defense budget? Does that have any impact on some of your programs or just timing of awards that we have to monitor? Curious what you guys are hearing on that front?

Really, from a CR perspective, that really shouldn't have any impact on our existing programs. It really, I think, is obviously had a little bit more impact if there is a government shutdown at some point. New program starting up might be effective but affected, but that really in terms of...

In '23, its pricing programs. So it's not going to impact '23.

Great. Good to know. And then just curious, is there are some signs of Access Equipment used pricing just sliding over the last few months. It's still elevated, but moderating from those highs. I'm just curious, when you look at your backlog and the price increases of the new equipment there, how should we kind of look at used Access and aerial values in that market?

Well, used equipment is, I think you have to look at it over periods of time, it's still elevated significantly versus where it normally is. So the fact that it came down a little bit. At this point, we don't think it means much. I think we need more data points to see a little bit more of a trend before we can make much of it. But just the moderation right now is not something that we think means anything at this point in time. And when I say that, Michael, I'm really talking about that because of the continued strong demand that we feel from the market and from our customers. And I'm talking about longer-term demand too, not just the here and now demand.

Make sense. Thank you.

Thanks, Mike.

Okay. Thank you, everyone for joining us today. We're committed, of course, to driving long-term profitability and growth as we continue to innovate, serve and advance our company. Stay safe, healthy, and we look forward to speaking with you throughout 2023.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.