Earnings Call Transcript - WAB Q3 2023

Operator, Operator

Good morning, and welcome to Wabtec Corporation's Third Quarter 2023 Earnings Conference Call. Please note this event is being recorded. I would like to turn the conference over to Kristine Kubacki, Vice President of Investor Relations. Please go ahead.

Kristine Kubacki, Vice President of Investor Relations

Thank you, operator. Good morning, everyone, and welcome to Wabtec’s Third Quarter 2023 Earnings Call. With us today are President and CEO, Rafael Santana; CFO, John Olin; and Senior Vice President of Finance, John Mastalerz. Today’s slide presentation, along with our earnings release and financial disclosures were posted to our website earlier today and can be accessed on our Investor Relations tab on wabteccorp.com. Some statements we’re making are forward-looking and based on our best view of the world and our business today. For more detailed risks, uncertainties and assumptions related to our forward-looking statements, please see the disclosures in our earnings release and presentation. We will also discuss non-GAAP financial metrics and encourage you to read our disclosures and reconciliation tables carefully as you consider these metrics. I will now turn the call over to Rafael.

Rafael Santana, President and CEO

Thanks, Kristine, and good morning, everyone. Let’s move to Slide four. I’ll start with an update on our business, my perspectives on the quarter, the progress against our long-term value creation framework, and then John will cover the financials. We delivered another strong quarter, evidenced by robust sales growth, margin expansion, and increased earnings and cash flow. We achieved these despite increased volatility and uncertainty in the economy. Sales were $2.5 billion, which was up 22.5% versus the prior year. Revenue was driven by strong performance from both the Freight and Transit segments. Total cash flow from operations was $425 million. Cash conversion was driven by higher earnings and improved inventory management. Overall, our financial position remained strong. We continued to execute against our capital allocation framework to maximize shareholder value by investing for future growth and returning cash to shareholders. The 12-month backlog was over $7 billion, up 13%, signifying continued momentum and visibility across the business into 2024. Total multiyear backlog was $21.5 billion. Overall, the Wabtec team delivered a strong quarter, behind solid execution. Looking ahead, I’m encouraged by both the underlying momentum across the business and the team’s unrelenting focus on delivering for our customers and even against the more uncertain and volatile macro environment. We believe Wabtec is well-positioned to drive profitable growth ahead. Shifting our focus to Slide five. Let’s talk about our 2023 end market expectations in more detail. While key metrics across our Freight business remain mixed, we continue to be encouraged by our business momentum, activity in international markets, and our robust pipeline of opportunities across geographies. North American carloads continue to be down in the quarter, which resulted in locomotive parkings being up slightly from last quarter’s levels. Yet we continue to see significant opportunities across the globe in demand for new locomotives, modernization, and digital solutions as our customers invest in solutions that continue to drive reliability, productivity, safety, and fuel efficiency. Looking at the North American railcar builds, demand for railcar continues to show growth. The industry outlook for 2023 is for about 45,000 cars to be delivered. Internationally, activity is strong across core markets such as Latin America, Australia, South Africa, and Kazakhstan, with significant investments to expand and upgrade infrastructure supporting a substantial international order pipeline. In mining, commodity prices are supporting activity to refresh and upgrade the truck fleet. Finally, moving to the Transit sector, the megatrends of modernization and decarbonization remain in place, driving the need for clean, safe, and efficient transportation solutions around the globe. Next, let’s turn to Slide six to discuss a few recent business highlights. During the quarter, we signed a strategic MOU with KTZ, the national railway company in Kazakhstan, for over $2 billion. This agreement will support significant freight growth through state-of-the-art equipment and technologies, driving productivity and lowering operating costs. This framework includes locomotives to be delivered in 2024, a long-term supply agreement, and a collaboration on a number of digital technologies, all of which we expect to drive strong orders and sales growth in 2024. Speaking of our business in Kazakhstan, the team just achieved a significant milestone by delivering its 500th locomotive. Looking at our mining business, the team signed orders totaling over $150 million, which is up double digits versus last year. Early in the fourth quarter, our team in Latin America won an order for 22 additional locomotives to be delivered in 2024. In North America, we won an order in New York City Transit to supply components for an additional 640 subway cars. Also, late last quarter, we closed the L&M acquisition that expanded our heat transfer portfolio in mining. This is off to a great start. The integration is on track. Third-quarter revenue is ahead of plan, taking advantage of a strong global mining market. I’d also highlight Nordco, which we acquired back in 2021. Our maintenance-of-way business continues to be ahead of plan and is experiencing double-digit growth in 2023. All of this demonstrates the continued momentum across the business, the team’s relentless focus on driving for our customers and the strong pipeline of opportunities we’re executing on. Wabtec’s well-positioned to capture profitable growth with innovative and scalable technologies that address our customers’ most pressing needs. Turning to Slide seven, I’d like to discuss in more detail our international markets. While North America provides us a solid foundation to refresh and renew our installed base, we also have a significant opportunity for growth across international fleets by leveraging our broad portfolio and superior technologies. We have been successful in expanding our international installed base over time, which has grown at roughly 4.5% annually for the last six years. Looking ahead, the pipeline of opportunities in our international markets continues to strengthen, and as a result, we expect continued expansion in our installed base. Increasing freight volumes from mining, agriculture, and intermodal continue to drive the need for increased investment in clean, efficient, and safe modes of transportation. We expect growth in 2024 from key regions like Latin America, CIS, Australia, and South Africa, driven by our regional footprints and local partnerships. Our technologies are delivering more fuel-efficient, reliable solutions, which will reduce operational costs for our customers around the world. With that, I’ll turn the call over to John to review the quarter, segment results, and our overall financial performance.

John Olin, CFO

Thanks, Rafael, and hello everyone. Turning to slide eight, I will review our third-quarter results in more detail. We delivered another good quarter of operational and financial performance from strong underlying momentum across the business, coupled with great execution from the team. Sales for the third quarter were $2.55 billion, reflecting a 22.5% increase from the prior year. Sales were driven by strong growth across both the freight and transit segments. For the quarter, GAAP operating income was $370 million, driven by higher sales and focused cost management. Adjusted operating margin in Q3 was 17.9%, up 1.5 percentage points versus the prior year. The increase during the quarter was driven by significantly higher sales, improved productivity, and cost management, partially offset by manufacturing inefficiencies driven by the strike at our Erie facility. GAAP earnings per diluted share were $1.33, which was up 51.1% versus the third quarter a year ago. During the quarter, we had pre-tax charges of $13 million for restructuring, primarily related to our integration 2.0 initiative to further integrate Wabtec’s operations and to drive $75 million to $90 million of run rate savings by 2025. In the quarter, adjusted earnings per diluted share were $1.70, up 39.3% versus the prior year. Overall, Wabtec delivered another strong quarter. We outperformed our expectations, demonstrating the underlying strength and momentum of the business, and as a result, we are fine-tuning our full-year outlook by increasing our sales and adjusted earnings guidance. Now, turning to slide nine, let’s review our product line in more detail. Third-quarter consolidated sales were very strong, up 22.5%. Equipment sales were up 38.8% from last year due to higher locomotive sales, which, as planned, were significantly skewed to Q3 versus Q4, along with increased demand for mining products this quarter. Component sales were up 32.3% versus last year, largely driven by higher North American OE railcar build and market share gains in freight car product sales, along with increased demand for industrial products. Sales also benefited from the strategic acquisition of L&M late in the second quarter by $42 million. Digital intelligence sales were down 3.2% from last year due to softness in our North American signaling business, partially offset by higher demand for international PTC, next-gen onboard locomotive products, and digital mining. Our services sales grew 17.6%. Sales growth was driven by higher modernization deliveries and increased parts sales. Our customers continue to recognize the superior performance, reliability, efficiency, and availability across their Wabtec locomotive fleets. Across our transit segment, OE and aftermarket sales significantly increased versus last year. Segment sales were up 20.0% to $660 million, behind execution of our growing backlog, easing of supply chain disruptions, and comparing against the cyber impact in Q3 2022. The momentum in this segment is strong across our core markets as secular drivers such as urbanization and decarbonization accelerate the need for investments in sustainable infrastructure. Moving to slide 10, GAAP gross margin was 31.0%, down 0.1 percentage points from Q3 last year, while adjusted gross profit margin was up 0.1 percentage points, driven by higher sales and improved productivity, partially offset by inefficiencies related to the strike in Erie. The mix was favorable, driven by a richer mix between and within segments. Raw material costs, while still elevated, were largely flat on a year-over-year basis. Foreign currency exchange was favorable to sales by $32 million, or 1.5 percentage points, and it improved our third-quarter gross profits by $7 million. Finally, manufacturing costs were positively impacted by favorable fixed cost absorption and benefits of Integration 2.0, more than offset by manufacturing inefficiencies, primarily at our Erie facility. Our team continues to execute well to mitigate the impact of continued cost pressures by driving operational productivity and lean initiatives. Turning to slide 11, for the third quarter, GAAP operating margin was 14.5%, which was up 2.0 percentage points versus last year, while adjusted operating margin improved 1.5 percentage points to 17.9%. GAAP and adjusted SG&A were $295 million. Adjusted SG&A as a percentage of sales was 11.6%, down 0.7 percentage points versus the prior year, as we leveraged higher sales and strong focus on managing costs. Engineering expense was $53 million, about flat with Q3 last year. We continue to invest engineering resources in current business opportunities, but more importantly, we are investing in our future as an industry leader in decarbonization and digital technologies that improve our customers’ productivity, capacity utilization, and safety. Now let’s take a look at segment results on slide 12, starting with the freight segment. As I already discussed, freight segment sales were very strong for the quarter, up 23.4%. GAAP segment operating income was $327 million for an operating margin of 17.3%, up 2.1 percentage points versus last year. Adjusted operating income for the freight segment was $399 million, up 30.0% versus the prior year. Adjusted operating margin in the freight segment was up 1.3 percentage points from the prior year at 21.2%. The increase was driven by significantly higher sales, including fixed-cost absorption and lower SG&A as a percentage of revenue, and improved mix, somewhat offset by manufacturing inefficiencies driven by the strike at Erie. Finally, the segment multiyear backlog was $17.61 billion, down 8.1% from the end of Q3 last year. We continue to compare against the multiyear modernization and locomotive orders, totaling over $1.5 billion that we received in 2022. The 12-month backlog was $5.28 billion, up 15.7% for the same period, and shows good momentum well into 2024. Turning to slide 13, transit segment sales were up 20.0% to $660 million. When adjusting for foreign currency, transit sales were up 14.5%. GAAP operating income was $68 million, up 28.3%. Restructuring costs related to integration 2.0 activities were $10 million in Q3. Adjusted segment operating income was $83 million, which was up 38.3%. Adjusted operating income increased as a result of higher sales, favorable mix, benefits from our integration 2.0 activities, and the cyber impact in Q3 2022. This resulted in adjusted operating margin of 12.5%, up 1.5 percentage points from last year. Finally, the transit segment multiyear backlog for the quarter was $3.87 billion, up 12.6% versus a year ago. Now let’s turn to our financial position on slide 14. Q3 cash from operations was $425 million versus $204 million in the prior year. Cash flow benefited from higher earnings and improved inventory management. Our debt leverage ratio was 2.1 times at the end of the third quarter, which was favorable versus the prior year. Finally, we returned $344 million of capital back to shareholders year-to-date through share repurchase and dividends. During the third quarter, we utilized free cash flow to pay down debt and reduce leverage after the $229 million acquisition of L&M in the second quarter of 2023. As you can see in these results, our financial position is strong, and we continue to allocate capital in a balanced strategy to maximize shareholder returns. With that, I’d like to turn the call back over to Rafael.

Rafael Santana, President and CEO

Thanks, John. Let’s flip to slide 15 to discuss our updated 2023 financial guidance. We believe that the underlying customer demand for our products and solutions continues. Our orders pipeline and 12-month backlog continue to be strong, providing solid visibility for profitable growth ahead. The team is committed to driving top-line growth and adjusted margin expansion in 2023, despite a challenging macro environment. With these factors in mind, we are increasing our previous guidance. We now expect 2023 sales of $9.5 billion to $9.7 billion, up nearly 15% from last year at the midpoint, and adjusted EPS to be between $5.80 and $6 per share, up about 21.5% at the midpoint. We continue to expect cash flow conversion to be greater than 90%. Looking ahead, while the macro environment has become more uncertain over the last quarter, I’m confident that Wabtec is well-positioned to drive profitable growth in 2024, which aligns with our long-term financial framework. Now let’s wrap up on slide 16. As you heard today, our team delivered another strong quarter. Even in a dynamic environment, we are committed to delivering on our value creation framework through the strength of our portfolio, resilient installed base, innovative solutions, and a rigorous focus on execution. Wabtec is well-positioned to drive profitable long-term growth and maximize shareholder returns. With that, I want to thank you for your time this morning, and I’ll now turn the call over to Kristine to begin the Q&A portion of our discussion.

Kristine Kubacki, Vice President of Investor Relations

Thank you, Rafael. We will now move on to questions. But before we do, and out of consideration for others on the call, I ask that you limit yourself to one question and one follow-up question. If you have additional questions, please rejoin the queue. Operator, we are now ready for our first question.

Operator, Operator

The first question is from Justin Long of Stephens. Please go ahead.

Justin Long, Analyst

Thanks, good morning and congrats on the quarter.

John Olin, CFO

Good morning, Justin.

Justin Long, Analyst

So maybe to start, I was wondering if you could quantify the strike impact at Erie in the quarter. And thinking about the guidance, the full-year outlook was raised, but it implies a sequential step down in earnings as we move into the fourth quarter. So John, can you give a little bit more color on some of the key drivers to that sequential pressure?

John Olin, CFO

Sure. We are very pleased to have reached a successful agreement with the union at Erie during the quarter. While we do not provide specific details on our cost of goods sold, it's important to note that the plant continued to operate during the strike, which contributed to our strong volume performance this quarter. However, it did operate at lower efficiency due to the reduced workforce. Overall, this impact slightly affected our earnings for the quarter, but we managed to deliver excellent results regardless. Regarding your second question about the implied growth in the fourth quarter, we are satisfied with how the second half of the year is shaping up, which is better than our earlier expectations shared during our Q2 earnings call. We have increased our revenue guidance by 2.5% at the midpoint and 4.5% for EPS, leading to an expected revenue growth of about 6% for the fourth quarter. This is notable considering last year's challenging comparison of over 11% growth. We also anticipate a significant increase in margins for Q4, with EPS projected to rise around 17% at the midpoint. When examining the second half, the growth in revenue for the third quarter is expected to outpace that of the fourth quarter, primarily because our production schedule is heavily weighted towards the third quarter. In fact, about 70% of our second-half locomotive deliveries will occur in the third quarter to meet customer expectations, as those schedules were established over a year ago. Nonetheless, the underlying growth for Q4 remains robust, supported by our increasing 12-month backlog, which is up 13% compared to last year. As mentioned by Rafael in the prepared comments, we anticipate seeing profitable growth as we transition into 2024.

Justin Long, Analyst

Okay. That’s helpful. And secondly, I wanted to ask about the backlog. We did see a sequential moderation. I know timing, particularly with some of the multiyear orders can move things around. So I’m curious if you’ve seen any slowdown in inquiry levels or the pipeline or if you would just chalk this up to timing. And on the Kazakhstan $2 billion MOU. Could you just confirm that’s not included in the backlog?

Rafael Santana, President and CEO

I’ll take that one, Justin. So first, no, it’s not in the backlog of orders, but talking about backlog, the backlog is healthy. It will be down year-over-year, but you got to look at it in conjunction with the multibillion orders that we signed last year, which don’t repeat every year. The outer side of it, we have a number of multi-billion-dollar opportunities that are forthcoming. We just signed a large one, which is in the pipeline and will convert into orders. So we see good momentum here. We don’t see a slowdown. We are progressing. We’re continuing to grow, and our pipeline supports it. Last quarter, as John said, the 12-month backlog last quarter was up 10%, this quarter, the third quarter was up 13%. We’re continuing to drive momentum here with key deals being signed and if you think especially about the long lead items in our portfolio like mods and your locomotives, you need that backlog to be there and as we look into 2024 and beyond.

Justin Long, Analyst

Okay, thanks for the time.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

The next question is from Jerry Revich of Goldman Sachs. Please go ahead.

Jerry Revich, Analyst

Yes, hi good morning everyone.

John Olin, CFO

Jerry good morning.

Jerry Revich, Analyst

Rafael, John, I wonder if you could just piece together a few of the comments that you made, it sounds like a pretty healthy order opportunity backdrop, U.S. railcar orders are constructive as well. So as we think about your 5-year outlook, it sounds like 2024 might be better organic growth revenue opportunity than a 5-year outlook that you provided, just putting the pieces together. And I’m wondering if you can confirm that, that’s how it’s tracking. And if you could touch on the level of margin improvement you can deliver, if it does indeed play out that way relative to the margin improvement CAGR that you’ve laid out on a 5-year basis? Thank you.

Rafael Santana, President and CEO

Jerry, we finished a strong quarter with a solid pipeline of opportunities, which has really enhanced our visibility to drive revenue and margin expansion. While it's a bit early to discuss specifics for 2024 guidance, I believe we will continue to see momentum, primarily from the strength of our short and mid-term backlog. The 12-month backlog stands at $7.1 billion, showing double-digit growth. Additionally, we are experiencing ongoing momentum with both new locomotives and modifications. Our customers are investing to reduce costs, leading to modernization which allows them to place orders for units. They’re focused on reliability as we emerge from a low point. It’s important to have a strong backlog given the longer lead times for modifications and new units, and we are well-positioned for the next 12 to 24 months. Internationally, we are optimistic about key markets and see significant momentum in Brazil, South Africa, and Australia as we head into 2024. On the margin front, the business will benefit from Integration 2.0, contributing to further expansion. Overall, our pipeline of opportunities continues to strengthen, and we are set to achieve profitable growth.

Jerry Revich, Analyst

Super. Really appreciate the comprehensive discussion. And can I ask on Transit? We’ve got a couple of orders of really good margin performance there. Has that business, in your mind, earned the right to grow off of these levels? I know you’re waiting until you felt really good about the sustainable margin performance. Are we at a point where we can think about that part of the platform top line accelerating given the improved execution over the past year plus?

Rafael Santana, President and CEO

Jerry, we’re pleased with the progress that we’re seeing there. We’re continuing significant work to simplify the footprint and further improve the business competitiveness. I think you’re going to continue to see some variation quarter-to-quarter, but that team is committed to continue to expand margins and take action here for profitable growth. Despite the more competitive environment, the fundamentals are good in the business. If you think about our book-to-bill ratio, we’ll close above 1 for the year. The 12-month backlog is up. Multiyear backlog is up 16%, the other one, I think over 12%. The team is continuing to progress to really drive mid-teen margins. So yes, we expect the business to be more competitive in the marketplace there, and we’re saying no slowdown. In fact, we see the opportunity here to continue to grow with the business. If you think about the record backlog some of our customers had, we’re continuing to see momentum there.

Jerry Revich, Analyst

Appreciate the discussion, thanks.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

The next question is from Ken Hoexter of Bank of America. Please go ahead. Hello, Ken, your line is open.

Nathan Ho, Analyst

Hi, sorry. This is Nathan Ho dialing in for Ken Hoexter. Congratulations to the team on the solid results. John, I think you commented earlier that mix was favorable to Freight gross margins. And I’m just looking through some of the segments. It looks like Equipment is up 40%, Components up 30%, yet Services and Digital are a little bit. I mean, Service is up 18% and Digital is down 3%. I understand the team doesn’t usually comment on segment level of margins. But could you maybe just talk a little bit more about the comment there and maybe some of the pricing and mix dynamics at play?

John Olin, CFO

Yes, Nathan. So number one, what you pointed out, what we said may be a little bit counterintuitive, right? But if you take it back to the discussion that we’ve been having for the last four quarters, when we really started to step up a lot of the locomotive deliveries internationally, that put a fair amount of overall mix pressure on us again, starting in the third quarter of 2022 and really going through the last four quarters. As we move out of the fourth quarter of 2023, we are stepping into higher-margin deliveries from a freight perspective. That’s shining through even though given the fact that overall equipment is at a lower margin than digital, we are still seeing, in aggregate, a fair amount of mix favorability. The other piece of it is not only mix within the various groups but also the mix between groups, right? When you look at the Freight growing at 23.4% and currency adjusted Transit at 14.5%, that provides a fair amount of mixed tailwinds as well.

Nathan Ho, Analyst

Perfect, thank you. And as my follow-up, I just wanted to maybe continue on the prior trend of thought on the backlog. I noticed just on the Freight side, it seems like this is the fifth quarter of sequential declines. I think just comping the multiyear backlog, this quarter versus Q2 were down $722 million. How should we read this? Is this any commentary on unit volumes or maybe something regarding pricing or mix? Any thoughts there would be helpful.

Rafael Santana, President and CEO

I think you’ve got to keep in mind, first, the lumpiness of the multiyear orders that we get. You’re going to see that lumpiness not just playing out through the quarters, but that lumpiness will play out in the years as well. As we mentioned, we expect the backlog to be down this year year-over-year. But the other side of it is the multibillion-dollar orders that we’re working on, which are not in our backlog, and we expect that to convert. I really look at us in terms of the lumpiness of the orders. The other piece you’ve got to be very focused on is when you think about the lead times on certain of your products, making sure that you have the coverage to work through it. That’s why I highlighted both modernizations and new locomotives; you need that backlog to be there, and we have it as we think about 2024 and beyond.

Nathan Ho, Analyst

Perfect. I appreciate it. Thank you.

Operator, Operator

The next question is from Scott Group of Wolfe Research. Please go ahead.

Ivan Yi, Analyst

Good morning. This is Ivan Yi on for Scott Group. My first question, you’re showing very strong EPS growth this year. What are the puts and takes to another year of double-digit EPS growth next year? Can you kind of walk through the moving parts there? Thank you.

John Olin, CFO

I think Ivan, it’s very much similar to what we experienced this year: one, volume growth does wonders for expanding margins, right, driving incremental growth. We’ve talked about our incremental growth is about 25% to 30%. With that incremental volume, which we would expect revenue growth in 2024, we will build EPS growth in addition to that. The other is, as Rafael had mentioned, Integration 2.0. That was a 3-year investment, and we’re just starting to get to the kind of the ramp on the savings plan. We’re seeing that ramp up in the first 3 quarters of this year, but expect the largest growth in terms of savings due to that program in 2024. So that, again, will drive margins a little bit faster than revenue. Overall, as we sit today and look forward to 2024, we expect that profitable growth that Rafael spoke to. With that, we expect to be overall in line with our long-term objectives and our long-term guidance.

Rafael Santana, President and CEO

I’ll reinforce two other points, which is just an element of international markets. I spoke here specifically about Brazil, South Africa, Kazakhstan, and Australia, which are very significant, and we have significant momentum walking into 2024 with this market. So we do expect significant growth there from a sales perspective. The other piece is, again, the coverage as we look into stepping into 2024, which is certainly one of the strongest coverages we’ve had stepping into any given year.

Ivan Yi, Analyst

Thank you. And then just a follow on, again, on the backlog. The one-year backlog is up nicely year-over-year, but the multiyear backlog, of course, is down. Can you just kind of go through that divergence? Why is that happening? And which one of those metrics is the better one to focus on, the one year or the multi-year? Thank you.

John Olin, CFO

First, go back to the things I've highlighted here. You’ve got to make sure you have the coverage, especially on the long-lead items. Otherwise, you’re getting an order for a new locomotive at this point, and you don’t have the coverage for 2024; there’s not much you can do there. So having the coverage for that long-lead items is important, and we have it. The second piece I talked about is the fact our fleets internationally continue to grow out. We’re seeing good momentum there, not just from a CapEx but also from an OpEx perspective. So that’s very positive. In North America, discussion continues despite, I’d say, continued growth in parking levels. Customers are investing for lower costs for improved efficiency and reliability. All in all, when we think about the momentum here, looking at North America and internationally, CapEx and OpEx, it continues to look like profitable growth going into 2024, very much aligned to the long-term guidance we’ve provided.

Ivan Yi, Analyst

Thank you.

Operator, Operator

The next question is from Matt Elkott of TD Cowen. Please go ahead.

Matthew Elkott, Analyst

Good morning. Thank you. If we take the guidance raise and the sequential moderation in the 12-month backlog together, is it because you have some deliveries that were scheduled for next year and were pulled forward to this year?

John Olin, CFO

No, no. Not at all, Matt. When we look at it, we’ve been talking about the year a lot in the first half, second half. At the beginning of the year, we said that first half would grow a little bit faster than the second half. The way to look at it between third and fourth quarter is to look at them together, and we’re seeing what you would see on the implied growth is 14% growth in the back half versus 16% growth in the first half. That’s what we’ve expected. It’s really a function of the way the production plan was set up over a year ago in terms of the deliveries we expected to make in third quarter versus the fourth quarter on some of our larger equipment, particularly locomotives. About 70% of the second-half production plan for locomotives is delivered in the third quarter versus the fourth quarter. When you even those out, we’ve had a year very much in terms of overall cadence expectations, of course, at a higher level of revenue growth, which explains the raise in the second and third quarter. The fourth-quarter underlying momentum is just as strong as the third quarter. We feel good as going into 2024 with the backlog growing, as Rafael mentioned; it’s actually sequentially grown for the last couple of quarters. As we exit the third quarter, it’s up 13%.

Matthew Elkott, Analyst

No, that’s very helpful to know. And just one follow-up question, John. Can you talk a bit more about the $2 billion Kazakhstan MOU? How much of it do you think could materialize in orders in 2024? And how much could materialize in deliveries in 2024?

John Olin, CFO

We’re not going to break out the timing of it, but we would expect all $2 billion of it to turn into orders. We’ve got a great customer in Kazakhstan, and they’ve got a tremendous growth opportunity, given some of the dynamics of the flow of products from China to Europe. We’re certainly working with them to upgrade their fleet and expand their fleet so that they can manage their future.

Rafael Santana, President and CEO

I would add the following. We expect a large part of that to convert. As I said, about some international markets, we’re increasing deliveries in Kazakhstan, and it’s strong growth going into 2024.

Matthew Elkott, Analyst

Perfect. Thanks, Rafael, thanks, John. I appreciate it.

Rafael Santana, President and CEO

Thank you, Matt.

Operator, Operator

The next question is from Saree Boroditsky of Jefferies. Please go ahead.

Saree Boroditsky, Analyst

Thanks, good morning. So kind of building on your comments, I think you mentioned the largest savings from integration 2.0 will materialize next year. Could you just provide an update on the progress you’re seeing there? How is it going versus expectations? And any way to quantify the margin benefit into 2024? Thanks.

John Olin, CFO

Yes, Saree. If you recall that Integration 2.0 was a 3-year program that started at the beginning of 2022. On any of these types of restructuring programs or opportunities to integrate, we’ll see a higher investment profile in the beginning and a higher savings profile in the back as we get the projects executed. To date, we’ve invested about $100 million out of an expected $135 million to $165 million over the 3-year period. What we’re seeing now is just as those projects start and either the facilities are being consolidated or products are being moved or however we’re looking at optimization, those savings are starting to build. At the end of 2022, we had ongoing savings of about $5 million, and that continues to escalate. We look for that to build up to $75 million to $95 million. We won’t quantify it, but you can start to see the momentum that we need to have to be at a run rate of $75 million to $95 million in 2025.

Saree Boroditsky, Analyst

Great. And then maybe this is kind of partially related, but Transit margins came in pretty strong, despite what typically would be a weaker seasonal quarter. So what kind of drove that margin improvement there? And how does this set you up as we look into 2024?

John Olin, CFO

Yes, we’re very pleased with the Transit margin. It was up 1.5 percentage points driven by a couple of things, Saree. Number one, is certainly fixed cost absorption was favorable given the volume growth ex-currency of 14.5%. The other area is product mix. Product mix was favorable in Transit. If you look at the aftermarket, it grew a fair amount faster than OE. When we talk about Integration 2.0, a fair amount of that hits our Transit business. That’s helping drive it. We’re lapping some of the inefficiencies that we had in cyber in the year-ago quarter. I feel very good about the transit business, as Rafael had mentioned, and certainly a bright future as we continue to move that business forward.

Saree Boroditsky, Analyst

Okay, thanks for taking the questions.

Operator, Operator

The next question is from Chris Wetherbee of Citigroup. Please go ahead.

Unidentified Analyst, Analyst

Hey good morning guys. It’s Rob dialing in for Chris this morning. Could you give us an update in terms of your delivery timing expectations for next year, like as of right now, are the orders more kind of first half or second half loaded? Or do you not yet have line of sight on that one?

John Olin, CFO

Yes, Rob, it’s a little bit early for us to start talking about gating. It’s early for us to talk about guidance as well. A typical cadence would be to provide guidance in the call in February after the year is done. Broadly, we’re looking at certainly profitable growth in 2024, but in another quarter’s time, we’ll have certainly more detail with regards to what that is and what’s driving it.

Unidentified Analyst, Analyst

That's helpful. It might be a bit too early to ask, but how does the current 12-month backlog mix compare to today’s mix? Do you have any insight on whether it's improving or deteriorating? We're trying to consider the various factors for next year.

Rafael Santana, President and CEO

I think more in terms of the coverage looking ahead, right? My comments on the strong coverage that it provides has really to be connected with long-lead parts of our portfolio. I think about new locomotives and I think about mods. And I think it in conjunction with both international markets and North America. That’s probably the strongest coverage we’ve had to walk into any year.

Unidentified Analyst, Analyst

Appreciate the color. Thanks Raf.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

The next question is from Rob Wertheimer of Melius Research. Please go ahead.

Robert Wertheimer, Analyst

Thank you. I just had two quick follow-ups. John, I think you’ve been pretty clear on the gross margin and some of the puts and takes. I wondered though, I mean, can you give any comment on just what normal gross margin leverage should be absent the strike or whatever and whether next year has any incremental labor pressure that would keep gross margin from rising? I mean, great fixed cost leverage across the enterprise, don’t going to be wrong, but more on the SG&A line. So just any comments on that would be helpful. Thank you.

John Olin, CFO

Yes. I think from a gross margin standpoint, what you’re seeing on a year-to-date basis is certainly a drag from the strike in Erie but also that mix that we talked about. We had mix headwinds in the first half, and that had an impact on gross margin. This quarter, gross margin was flat, again affected by the strike at Erie, but a lot of benefits as we move forward. When we look at Integration 2.0, that directly fits into the gross margin, and we would expect a tailwind on margins because of that. The biggest driver of margin is volume, right, and leveraging the fixed cost structure of the business. That’s not only fixed manufacturing costs but also the fixed portion of SG&A. As we grow, we expect to continue to aggressively manage our cost structure and making sure that we do deliver those incremental volumes, which, again, we would expect to be in the 25% to 30% range.

Robert Wertheimer, Analyst

Perfect. Thank you. And then one last one to close out mining really strong, I think, particularly for some of your customers. Any sign that that has peaked out? Are we still early in that cycle? Just any commentary there and then I will stop.

Rafael Santana, President and CEO

It continues. Mining is very strong right now, and all the indications we’ve got is of that momentum continuing into next year as well. So that’s certainly one of the positive momentum that we see in the business.

Robert Wertheimer, Analyst

Thank you.

Operator, Operator

The next question is from Steve Barger of KeyBanc Capital Markets. Please go ahead.

Steve Barger, Analyst

Hey, thanks, good morning. Rafael. Backlog has been stable at around $22 billion for the last 5 years post the GE deal. Do you think of that as a natural run rate, meaning if things go to plan, it will be around the same 5 years from now? Or the way it’s structured, does monetization speed up at some point, meaning revenue accelerates but backlog contracts? How do you think about that long-term?

Rafael Santana, President and CEO

Rob, I won’t provide specific numbers for the next five years. Instead, I’d like to share how we are operating the business. We are strongly focused on ensuring we have the necessary coverage for future growth that is profitable. This has been a significant area of attention. In the past, there was considerable emphasis on multiservice agreements that offered long-term coverage for fleets. We have balanced that with long-term parts agreements. Depending on the fleet specifics for our customers, we might consider different strategies. Overall, we have to manage these aspects and concentrate on the value we provide, especially as we create more opportunities to enhance fleets with upgrades in fuel efficiency and other areas. Our goal is to ensure we are adding value for both our customers and ourselves. We aim to maintain this momentum and drive profitable growth. Does that clarify things?

Steve Barger, Analyst

Yes, I think so. If I can just boil that down, it sounds like you do expect when you look at your pipeline and how you try to manage the business that you’ll have 2x the forward years revenue in backlog for the foreseeable future? Is that fair?

John Olin, CFO

I don't believe we can establish a clear index for it. Over the past five years, our backlog has fluctuated between 21.5 and 22.5. Economic conditions play a role in this. When we experience significant orders, we see the backlog increase, and then it tends to decrease as those orders are fulfilled. We've observed this trend from 2022 to 2023, where the backlog grew by about $1 billion in 2022. As we process those orders, we are comparing against those figures, and the backlog has decreased by 4% or 5%. Over the long term, we anticipate that it will rise, but I don’t think it can be quantified with a formula. It’s often inconsistent, depending on multi-year factors. The best way to mitigate this inconsistency is to analyze the backlog over a 12-month period. By doing this, we can smooth out the fluctuations, and the 12-month outlook has remained steady and has gained momentum over the past three quarters this year.

Rafael Santana, President and CEO

This is a business that goes before the transactions were done. There was a lot of, I’ll call, ups and downs through the cycle. One of the things that the team has been purposeful about is making sure we are working with customers to drive what I’ll call sustainable investments moving forward, which plays well for the entire ecosystem. It’s a piece of making sure that we’re ultimately getting to the right quality, the right value for the products ultimately to drive costs as we run some of these programs. That’s been a huge focus. The focus on 12-month backlog and longer-term agreements will play into making sure we’ve got the continuation of a lot of the infrastructure that we can use to support the delivery of some of these assets for customers around the world.

Steve Barger, Analyst

Yes. That’s good color. And the only comment I’ll make is mid-single-digit percentage variance around a $21 billion 5-year average is not that lumpy. I think a lot of companies would love to have that. As my follow-up, John, I know you don’t want to get into specific line items around the strike, but this was a record quarter for Freight revenue and the best segment margin since 2019. Can you tell us what revenue and margin could have been? Is it fair to say this quarter will not be a high watermark as we think about Freight in 2024?

John Olin, CFO

We expect to continue to grow this company in 2024, 2025, and 2026, Steve, and well beyond that. No, I can’t pull out what it would look like without. All I can say is it was a tremendous effort on the part of the overall company to be able to deliver that revenue growth. I talked about the locomotive piece, right, and that shift. We delivered all the locomotives in the second quarter that we were intending to deliver with the 10-week strike at our largest plant that makes locomotives. It’s a tremendous tribute to the team and how the whole company pulled together to continue to work through the strike.

Steve Barger, Analyst

Got it. Thank you.

John Olin, CFO

Thank you.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Kristine Kubacki for closing remarks.

Kristine Kubacki, Vice President of Investor Relations

Thank you, Kate. And thank you, everyone, for your participation today. We look forward to speaking with you again next quarter.

Operator, Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.