Allison Transmission - Q2 2014
July 24, 2014
Transcript
Operator (participant)
Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's second quarter 2014 earnings conference call. My name is Melissa, and I will be your conference operator today. At this time, all participants are in a listen-only mode. After the prepared remarks, the management team from Allison will conduct a question-and-answer session, and conference participants will be given instructions at that time. As a reminder, this conference call is being recorded. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. I would now like to turn the conference over to Dave Graziosi, the company's Executive Vice President and Chief Financial Officer. Please go ahead, sir.
David Graziosi (EVP, and CFO)
Thank you, Melissa. Good morning, and thank you for joining us for our second quarter 2014 results conference call. With me this morning is Larry Dewey, Allison Transmission's Chairman, President, and Chief Executive Officer. As a reminder, this conference call, webcast, and the presentation we are using this morning are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through July 31. As shown on page 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These forward-looking statements are subject to known and unknown risks, including those set forth in our second quarter 2014 results press release and our annual report on Form 10-K for the year ended December 31, 2013, and uncertainties and other factors, as well as general economic conditions.
Should one or more of these risks or uncertainties materialize, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those we express today. In addition, as noted on page 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached as an appendix to the presentation and to our second quarter 2014 results press release, both of which are posted on the Investor Relations section of our website. Today's call is set to end at 9:00 A.M. Eastern Time. In order to maximize participation opportunities on the call, please limit your questions to one with one follow-up question. Now I'll turn the call over to Larry Dewey.
Lawrence Dewey (Chairman, President, and CEO)
Thanks, Dave. Good morning, and thank you all for joining us today. Our second quarter 2014 results are within the full year guidance ranges we affirmed on April 16. Net sales improved on a year-over-year basis for the third consecutive quarter, led by the continued recoveries in the North America on-highway and off-highway end markets, partially offset by weakness in the outside North America end markets. Allison continued to demonstrate strong operating margins and free cash flow while aligning costs and programs across our business with end markets' demand conditions and growth opportunities. During the quarter, Allison continued its prudent and well-defined approach to capital allocation by returning capital to its shareholders through a $150 million share repurchase and payment of a dividend.
We are updating our full-year net sales guidance to an increase in the range of 4%-6% year-over-year due to anticipated improvements in second half demand conditions in the North America on-highway and off-highway end markets, weakness in the outside North America on-highway end market, and previously contemplated reductions in U.S. defense spending. Please turn to slide 4 of the presentation for the call agenda. On today's call, I'll provide you with an overview of our second quarter performance, including sales by end market. Dave will review the second quarter financial performance, including adjusted EBITDA and adjusted free cash flow. I'll wrap up the prepared comments with the full-year 2014 guidance update prior to Q&A. Please turn to slide 5 of the presentation for the Q2 2014 performance summary.
Net sales increased 4.7% from the same period in 2013, principally driven by the continued recoveries in North America on-highway and off-highway end markets, and higher demand in the service, parts, support equipment, and other end market, partially offset by lower demand in the outside North America end markets and previously contemplated reductions in U.S. defense spending. Gross margin for the quarter was 44.5%, an increase of 30 basis points from a gross margin of 44.2% for the same period in 2013. The increase in gross profit from the same period in 2013 was principally driven by increased net sales and price increases on certain products, partially offset by unfavorable material costs.
Adjusted net income increased $28 million from the same period in 2013, principally driven by increased adjusted EBITDA and decreased cash interest expense. Adjusted free cash flow increased $15 million from the same period in 2013, principally driven by increased net cash provided by operating activities. Please turn to slide 6 of the presentation for the Q2 2014 sales performance summary. North America on-highway end market net sales were up 13% from the same period in 2013, principally driven by higher demand for Rugged Duty Series and Pupil Transport Shuttle Series models, and up 4% on a sequential basis, principally driven by higher demand for Rugged Duty Series and Pupil Transport Shuttle Series models, partially offset by lower demand for Highway Series models....
North America Hybrid Propulsion Systems for transit bus end market net sales were up 4% from the same period in 2013, and 17% sequentially, principally driven by intra-year movement in the timing of orders. North America off-highway end market net sales were up 188% from the same period in 2013, and 92% on a sequential basis, principally driven by higher demand from hydraulic fracturing applications. Defense end market net sales were down 16% from the same period in 2013, and up 44% sequentially, principally driven by previously considered reductions in U.S. defense spending to longer-term averages experienced during periods without active conflicts, partially offset by the recognition of previously deferred revenue totaling $16 million, commensurate with the shipment of certain tracked transmissions at the request of the U.S. government.
Outside North America, on-highway end market net sales were down 17% from the same period in 2013, reflecting weakness in China, Western Europe, and South America, and down 3% on a sequential basis, reflecting weakness in China, partially offset by Japan. Outside North America, off-highway end market net sales were down 33% from the same period in 2013, principally driven by weaker demand conditions in the energy sector, partially offset by higher demand from the mining sector, and up 14% sequentially, principally driven by modestly improved demand conditions in the energy sector.
Service parts, support equipment, and other end market net sales were up 16% from the same period in 2013, and flat on a sequential basis, principally driven by higher demand for North America service parts and North America on-highway support equipment, commensurate with increased transmission unit volumes. Now I'll turn the call back over to Dave Graziosi.
David Graziosi (EVP, and CFO)
Thank you, Larry. Please turn to slide 7 of the presentation for the Q2 2014 financial performance summary. Given Larry's comments, I'll focus on other income statement line items and Adjusted EBITDA. Selling general administrative expenses were $85 million, essentially flat with the same period in 2013. Engineering, research, and development expenses decreased $2 million from the same period in 2013, principally driven by reduced product initiatives spending. Interest expense net increased $3 million from the same period in 2013, principally driven by less favorable mark-to-market adjustments for our interest rate derivatives, partially offset by debt repayments and lower rates for our LIBOR swaps and senior secured credit facility. Other expense net decreased $2 million from the same period in 2013, principally driven by gains on derivative contracts and favorable foreign exchange, partially offset by lower grant income.
Income tax expense for the second quarter of 2014 was $38 million, resulting in an effective tax rate of 40% versus an effective tax rate of 38% in the second quarter of 2013. The effective tax rate increase was principally driven by the change in discrete activity. Adjusted EBITDA for the quarter was $186 million, or 34.7% of net sales, compared to $172 million, or 33.5% of net sales for the same period in 2013. The increase was principally driven by increased net sales, price increases on certain products, and reduced product initiative spending, partially offset by unfavorable material costs. Please turn to slide 8 of the presentation for the Q2 2014 cash flow performance summary.
Allison continued to demonstrate solid free cash flow conversion and a well-defined capital allocation policy focused on the return of capital to shareholders while pursuing a prudent level of net leverage. Allison ended the quarter with $127 million of cash, $453 million of revolver availability, and net leverage of 3.82. Now I'll turn the call back over to Larry Dewey.
Lawrence Dewey (Chairman, President, and CEO)
Please turn to slide 9 of the presentation for the full year 2014 guidance update. Our updated full year 2014 guidance includes a year-over-year net sales increase in the range of 4%-6%, an Adjusted EBITDA margin, excluding technology-related license expenses, in the range of 32.5%-34%, an Adjusted Free Cash Flow in the range of $385 million-$425 million, capital expenditures in the range of $60 million-$70 million, and cash income taxes in the range of $10 million-$15 million.
In the second half of 2014, we expect net sales to increase on a year-over-year basis, principally driven by improved demand conditions in the North America on-highway and off-highway end markets, weakness in the outside North America on-highway end market, and previously contemplated reductions in U.S. defense spending. Although we're not providing specific third quarter 2014 guidance, Allison expects net sales to be higher than the same period in 2013. The anticipated year-over-year increase in third quarter net sales is expected to be principally driven by higher demand in the North America on-highway and off-highway end markets, partially offset by previously considered reductions in defense net sales. Melissa, please open the call for questions.
Operator (participant)
Thank you. At this time, we'll be conducting a question and answer session. If you would like to ask a question, please press *1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press *2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the * keys. Our first question comes from the line of Ross Gilardi with Bank of America Merrill Lynch. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Yeah, good morning. Thanks, guys.
Lawrence Dewey (Chairman, President, and CEO)
Good morning.
Thomas Robyn (Equity Research Analyst)
I just had a couple questions. First, I think you're at about 3.8x leverage right now, and on our numbers, you're at, you know, about 3.5x by year-end 2014, and I think that'd probably be where consensus numbers would be, too. So it seems like only a matter of time before you're at your 3-3.5x leverage target. Is it just a matter of crossing the threshold on 3.5x before you begin returning cash more significantly, or would you rather be near the lower end of the range?
Lawrence Dewey (Chairman, President, and CEO)
I think there's a number of options that we're looking at, Ross, for the capital allocation going forward. As you know, we've indicated to the market the 3.5 level as a near-term target. Having said that, you know, we're constantly evaluating our capital structure and the debt markets, and I would certainly submit that, you know, our focus remains getting cash back to shareholders. The ultimate forms we look to further refine here over the next 6-12 months with, in conjunction with the board. I would look for us to come out with some more specific guidance on that as the second half evolves.
Thomas Robyn (Equity Research Analyst)
Okay, great. Thanks, Dave. And then, obviously, you guys don't give, you know, long-term, you know, earnings guidance, but I was just curious on sort of what your overall feelings are on the sort of the multiyear directional view on North America on-highway. I mean, unlike the heavy duty, you know, Class 8 market, seems like you've got a longer, you know, more gradual runway to grow in that market over the next several years. And would you, you know, generally agree with that statement? And then any granularity you could provide on what you're seeing in the different end markets?
David Graziosi (EVP, and CFO)
Sure. Number one, we do in fact see a longer runway on it, more gradual, as you've described it, in particular, the medium duty, and Class 8 straight truck, which is, of course, you know, our relevant markets. Even the short haul is probably less volatile than the line haul, where we sell some of our Highway Series, and of course, we're bringing our TC10 into that space as well, and getting some traction on that here, relative to interest and some orders flowing in. You know, if you look across the various sectors, you know, the end markets of our business, I think we're seeing, you know, some improvement in municipal. It's not all the way back.
You know, there's still some people fighting through some tax receipts issues, particularly some of the more challenged municipalities, but we're continuing to see improvement there. Certainly, some of the commercial lease rental, consumer rental business, you know, that's been strong. Some of the package delivery business has been strong. You know, there's one of our OEMs has gotten some significant additional business from, I believe it's UPS, I saw on some of the notes. And so certainly that's moving our way. One that hasn't had, and I'm not suggesting that it's a huge uptick, but has actually seen some improvement from some very depressed levels, is the motor home market. We've actually seen some little bit of uptick there, as well, here in North America.
The other thing, that's going on in North America is in the bus space, transit business, for the conventional products, you know, I think we've seen some nice business there, including some where we're getting some interest from some fleets that have been longtime users of some of the competitive products, and that's something that certainly we're responding to, and frankly, want to understand some of their interest and what the basis for that is so we can continue to push even harder at some of the fleets maybe that haven't yet stepped forward, that have been using some of the competitive products. So there's a number of areas where we feel good, but you know, there's always work to do.
We got to make it happen. There's some penetration we've gotten in construction. We've had some targeted programs here through the first 3, 4 months of the year, focused on non-user conquest selling, and have been successful at placing small quantities, frankly, because it's the trial basis. You know, they try a few, as we've talked about on a number of calls, but nonetheless, there are a number of fleets that, for the first time ever, are using Allisons in their fleet, and we're confident and that, as they get that experience, we'll be able to persuade them between the product performance attributes and the support that we provide.
you know, we would expect that a number of those would continue and indeed expand their purchases, and that's why we do those programs.
Thomas Robyn (Equity Research Analyst)
Okay, great. I'll get back in queue. Thank you.
Lawrence Dewey (Chairman, President, and CEO)
Thank you.
Operator (participant)
Thank you. Our next question comes from the line of Andrew Kaplowitz with Barclays. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Hey, good morning, guys. Nice quarter.
Lawrence Dewey (Chairman, President, and CEO)
Morning. Thanks, Andrew.
Thomas Robyn (Equity Research Analyst)
Larry, can you break down where the weakness was a little bit more in non-North American on-highway? You know, it obviously got a bit worse here in 2Q versus expectations. We know Europe was weak, but maybe talk more about China, you know, and then Russia, Venezuela, some of the small pieces. And then just real quickly, like, I know your guidance was... You probably don't want to go over specific guidance on this particular segment, but, you know, it was +10. Obviously, it's not going to be that. You know, is something like down mid-single digits how we should think about it for the year?
Lawrence Dewey (Chairman, President, and CEO)
Yeah. Let's take a quick tour around the world, and you know, let me start out by saying, clearly, there's some headwinds that one could argue are beyond our control. Certainly, geopolitical events involving Russia is not something we control. That said, I do think that you know, there are some things that we can do, and I'll be spending some more of my time in this space to make sure I'm providing the appropriate level of encouragement and support for the initiatives. But if you go around the world... You know, Russia, we were feeling very good about the release activity and some of the groundwork that had been laid. And obviously, with some of the events, frankly, a lot of things were already seizing up in Russia.
You know, truth is not even necessarily tied to the sanctions, just to the consequences of some of the sanctions and some of the loss of business confidence over there. So that's one that we've spent a couple of years on and really felt like we were poised to start breaking out in 2014 and beyond. And that's, you know, certainly disappointing. And, you know, beyond that, I won't offer any further commentary. You know, we'll obviously follow all government dictates and, you know, be within the law. And we'll have to wait until, you know, some of the relations are a little more normalized, I think. Turkey was one I should have mentioned. I mentioned Western Europe being a little soft, and I'll come back to that.
But Turkey is one where, you know, we've done some nice work in bus sales there. That's another one where it's gotten a little choppy as a result of some allegations of corruption, again, not involving us, but some of the government folks. So that's really dried up a bit here, not unlike the situation we had in India for a couple of years, unfortunately. So, you know, we feel good about our positioning, but, you know, the market's bound up a bit. China, you know, you got the bus. I think we're still well positioned there. That really goes to some of the tenders. Two things: number one, they have kind of made a, I'll call it a near-term trial order.
Some of the tenders have been converted to domestic electric, I'll call it, vehicles. You know, certainly we're you know, we've got some product that we'll be looking at here into that space. I think they're gonna be challenged based on the duty cycles with the batteries, battery life and performance. But nonetheless, you know, when the government there says, "We'd like to take a step in this direction," you know, the fleets follow that here, and that's happened to a couple of near-term tenders. You know, we haven't really, in that sense, I don't think, lost any conventional positioning, but they certainly have... There's one significant tender that's gone that way. Beyond that, I think we're well positioned.
Truck, we're gaining, but frankly, not at the pace that we had originally budgeted. So on the one hand, it's, you know, you can see some of the progress, and I would expect that to accelerate as a result of some organizational changes we've made. But nonetheless, you know, that's not meeting the targets we had set, even though they're making progress. India, we're starting again to see things break loose, so that's good, but a little later and a little smaller than what we had in the original plan. So again, kind of a sweet and sour situation there. You know, I think that will come to us. It's a question of the timing of some of the tenders and just how much business is gonna flow.
Again, we feel good about the positioning there. Argentina and Venezuela and Latin America, you know, I think we're all familiar with the situation there. That's not an insignificant couple of markets for us, and those have obviously had some problems. Touched on Western Europe being slow, and I think that we had not properly understood at the end of 2013 exactly what pre-buy had occurred. The other issue, in talking with one of the large Germanic OEMs that we do business with, they indicated that in the municipal, largely municipal over their space and some of the private fleets as well, some of their, we might call it severe service, heavy vocational-type vehicles, where we typically play, that they're anticipating about a 25% year-over-year downtake in that space.
So that's something that we're trying to factor into our numbers as we go forward. On the plus side, you know, Australia's probably come back a little quicker than we would've thought in terms of the macros. So that's been a nice piece, and some of that flows through Japan. And in Japan, you know, I think some of the work that's gone on, geez, over probably 3 or 4 years here with end users is finally starting to pay off on the domestic market. So that's been a bright spot, albeit of a lower magnitude. So that's kind of an around the world kind of a view. And certainly, your assessment of the year-over-year net result, given all of those headwinds, is probably not unreasonable.
Like I say, you know, some of those things I can accept that there's some headwinds that are beyond our control, but you know, we don't control the wind, but we do adjust the sails, and so we've got some work to do.
Thomas Robyn (Equity Research Analyst)
Okay, thanks for that, Larry, and then that's very helpful. If you look at your three highest margin businesses, you know, which you've said in the past, Parts, North American On-Highway, North American Off-Highway, you know, these are the businesses that are sort of leading the charge for you. So why wouldn't your mix shift really help you from what was already a good first half of the year in terms of EBITDA margin? I mean, we understand the weakness, you know, in non-North America, but still, it seems like you could get to the high end of the range as long as we see something like what we just saw in 2Q.
David Graziosi (EVP, and CFO)
I would say, certainly with the, you know, pleased with the margin development in the second quarter. As we pull together our guidance for the second half, you know, as Larry indicated, certainly some of our visibility around outside North America continues to be a bit challenged. North America, to your point, in terms of some of the higher margin businesses are certainly pulling in the right direction. Having said that, we also have some additional spending plans in the second half around our engineering group and some initiatives. Again, it's nothing.
... different, frankly, from our usual process. It's more of a cadence of the execution of, specific initiatives, so there's, there's heavier spending there, as well. And, and I would say on the, SG&A side, some additional, work that we're doing in the second half is historically, you would see us, ramp some of our spending, related to marketing events, specifically around the third quarter. And on a year-over-year basis, if you look at the, the second half last year, we also had some favorable, experience in warranty that was, recognized in the third quarter of last year that we're not at this point anticipating for the third quarter of this year. So a number of drivers there.
You know, I would say as our positioning has been in the past, you know, we pull together guidance. We take a view of certainly being prudent about the, you know, the outlook at the same time. I would not necessarily disagree with your view that things could go a bit higher relative to our range there. But, you know, we'll, as we get further into the second half and update with third quarter, you know, we can certainly revisit that.
Operator (participant)
Thank you, guys.
Lawrence Dewey (Chairman, President, and CEO)
Thanks.
Operator (participant)
Thank you. Our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Hi, good morning.
Lawrence Dewey (Chairman, President, and CEO)
Morning.
Operator (participant)
Morning, Jerry.
Thomas Robyn (Equity Research Analyst)
Can you gentlemen just talk about within your pressure pumping business, what was the parts performance like in the quarter? Just give us a sense for order activity as well. I guess based on what we're hearing, we would imagine your lead times are starting to widen out, but maybe you could give us an update. And also, can you just touch on what's the order mix of your newly expanded high-end product lines and pressure pumping as well?
Lawrence Dewey (Chairman, President, and CEO)
Well, let me answer them in reverse order there. In terms of the new products, you know, we've just seen some of the folks converting over. One of the things we're doing this time to make sure that the launch goes extremely well is we have queued up the rig engine pump combinations. And in the past year, we've really advanced our state-of-the-art relative to understanding the total rig system with analytical models based on the data we've gathered. And so with the new product, before we will allow someone to use it and receive those benefits, we make sure that we go out and we instrument and we test the rig, and essentially kind of certify, if you will, the installation. So that process is ongoing.
We do have units that have gone to China. We've got folks coming in on board here in North America. Probably our largest single customer in that space, in the energy space, will be converting a little later this year, as their rig configuration evolves to take advantage of some of the new capabilities of the new product. So that's kind of where we're at. We're pleased with the reception. We think the customers are gonna be very happy with the performance. It obviously takes us into a space with the higher horsepowers, where we have not previously been. And so we're kind of excited about that because that gives us a chance to go at it with some folks that are in that space currently.
Relative to the parts, the aftermarket net sales, of course, as you've probably noted in your analysis, is up sequentially now 6 consecutive quarters, and in year-over-year, 5 consecutive quarters. You know, we do see, you know, we have seen a surge here in the first half. We do expect the high level to continue. We don't expect the rate of increase to continue. We think we're kind of—we've reached a, you know, at least in the near term here, kind of a terminal velocity, if you will, at this higher level. So I wouldn't lay a straight edge on it. What I would do is if you did, take that first half and lay the straight edge across rather than on the increasing slope there.
You know, we think that there could be, you know, we're watching closely some of the rigs that are exported here from North America. You know, the average age of those is about 10 years. They go to other places in the world where you know, some of the duty cycles and regulations are a little bit different than here in North America. So, you know, we certainly want to be positioned globally for any potential service parts there as well. But that's kind of our take on the service parts piece of it, Jerry.
Thomas Robyn (Equity Research Analyst)
Okay, thank you. And, Larry, can you just provide some more color on what you're seeing on the applications in China? How's their pressure pumping ramp going? What are the run rates like? You know, what does the parts stream tell you about how they're being run? And, you know, what are you seeing in terms of how successful the developments are there for the customers?
Lawrence Dewey (Chairman, President, and CEO)
You know, we've... It's interesting because, very often in that market, whether it's on-highway or off-highway, when you have a new initiative launched by an OEM, what you see is a very, you know, it's a very aggressive industry, I guess I would say, where they have very aggressive plans. And frankly, they put their money behind that in terms of building a bunch of product. And frankly, their ramps typically don't match the initial surge. And so you have kind of this binge and, and, you know, wean, I guess, maybe, process. And we're kind of, you know, in-- we're still in what we think is the digestion process, maybe it's a better way to say it, binge and digest. We're still digesting in the energy space.
They, they clearly have an appetite for higher horsepower. So
me of that gets to some of the bridge laws we have in this country. Some of it gets down to the nature of the work in China. If it's remote and difficult to get to, it's a lot easier to get 8 rigs instead of 10 rigs there. And so if you need X amount of horsepower to get the job done, you better have that kind of a greater ratio of horsepower on that rig when you get it to the site. So that's one factor.
The other factor is, you know, there was an article, I think, in the New York Times here recently that talked about how, by some estimates, the effort is three times as hard as some of the other fields here in North America to extract the energy. So that, again, would imply a need for higher horsepower, which is lining up. I mean, they were the first ones to. In fact, we accelerated our production ramp to get them some units initially to get into the field to see how they liked them. They were the first ones to come on board with some of the higher horsepower.
Thomas Robyn (Equity Research Analyst)
Okay. Thank you very much.
Lawrence Dewey (Chairman, President, and CEO)
Yeah, thank you.
Operator (participant)
Thank you. Our next question comes from the line of Jamie Cook with Credit Suisse. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Hi, good morning, and nice quarter. Just a couple questions. One, you noted in your presentation and in your prepared remarks that material costs were higher. Can you just talk about where it was relative to your expectations, and has your expectations for material costs changed throughout the year? My second question, could you just give a little color on what you're seeing in mining broadly? Any signs of hope there in terms of a bounce off the bottom? And then my last question, Dave, just to clarify, you answered the margin question related to Andy, but I just wanna make sure. I think last quarter, you said SG&A would be flat and engineering down slightly year-over-year. Has your expectations for the year changed? Thanks.
David Graziosi (EVP, and CFO)
Just a couple things. In terms of your question on material costs, certainly not, you know, that significant. If you think for the quarter, it's roughly $3 million, as you'll see when we file the Q. And I would say overall, expectations for the year are really not that different from what we started with. Our teams continue, I think, to make some good progress, frankly, on a number of supply chain initiatives. You know, I think our global footprint, as we've talked before, provides us with some new opportunities relative to that space as well. But there really isn't anything that significant. I think, you know, as Larry talked about with managing schedules, lead times, we haven't seen anything significantly different, frankly, from what we expected coming into the year.
On the SG&A, your question there, a couple things. As we have updated, frankly, our spending numbers and some of our programs overall for the year, we also made some, some reclassifications within, the P&L, and you'll, you'll see that in, in the, 10-Q in more detail. But, certainly there, there is a reclass on a net basis in terms of the impact on EBITDA. There really isn't an impact. It's a reclass, as I said. On the engineering, side, we'll essentially be expect to be more or less flat, year-over-year. As I said earlier, some of the initiatives we have relative to, product development, is more weighted in the second half at this point, and that's just the cadence of, how we rolled up the programs.
There isn't anything relative to a push or a delay or deferral on our part in terms of timing. It more really has to do with the execution of those particular programs. But we certainly feel good about the status of those initiatives and the value that they potentially create and will deliver for the shareholders.
Lawrence Dewey (Chairman, President, and CEO)
Yeah, within that product engineering piece, just to add a little more color here. There's actually we've been able to increase some scope, even within the numbers. We're continuing to do more work in the horsepower, expanding our horsepower upwards in the off-highway space, continue to do refinement work with the H3000 as even as we fielded some prototype units. So there's you know, pleased with what engineering is getting done. And then, of course, our other, our Fallbrook and our Torotrak, that's really purely timing. That continues to be within the scope that we had outlined. So that's you know, we feel pretty solid that we're getting some good things out of the product folks.
As far as your comment about the mining, it would be fair to say that, you know, certainly we do continue to say that the rebound is sluggish. That might be a nice way to say almost non-existent in a number of areas. From the standpoint of the Allison business, probably two significant pieces. Certainly one of our large European customers was just acquired by Volvo Construction Equipment, and they are understandably looking over their inventory policies, and so I think they're drawing that down a bit, which results in some near-term lower requirements as they bring inventories more in line with what the new ownership would like to see.
The second one is, and this kind of gets back to some of my comments about the China market in general, and certainly it applies in this space. One of the key horses we're riding in China, in the off-highway space, off-highway mining, is Sany. They've certainly made it known what their intentions are and have opted for Allison products in their portfolio. They were very aggressive in ramping up their production build... and, you know, they haven't been able to take all of those vehicles into the market at the pace that they would have liked. So then they have, in turn, reduced their schedules here, the rest of the year as they continue to build their volume of vehicle sales.
Thomas Robyn (Equity Research Analyst)
Okay, great. Thank you. I'll get back in queue.
Operator (participant)
Thank you. Our next question comes from the line of David Leiker with Baird. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Good morning, everyone.
Lawrence Dewey (Chairman, President, and CEO)
Good morning.
Thomas Robyn (Equity Research Analyst)
Just a couple of quick, you know, follow-ups here. On the international markets, Larry, as you went through, I don't believe I heard you talk about Europe in total.
Lawrence Dewey (Chairman, President, and CEO)
I'm sorry?
Thomas Robyn (Equity Research Analyst)
I don't think you talked about Europe in total, of what was going on in the market there for you.
Lawrence Dewey (Chairman, President, and CEO)
Well, I guess a couple things, and I'll speak. You know, I talked about Turkey, okay? The other one I didn't mention was South Africa as a result of some of the challenges they've had down there. The mining market, which uses those vehicles use a variant of our on-highway products, the Rugged Duty Series, the articulated dumps out of Bell. That's certainly been challenged. And then in the on-highway space, some of the labor strikes have had an impact on some of the general economic conditions there, so that hasn't been helpful. Talked a little bit about Turkey, talked a little bit about Russia.
Western Europe, touched on that relative to, the pre-buy that, that, you know, certainly in the first quarter and first half here has, has impacted us a little bit. And then the comment on the, the, what I'll call the, the rugged or the more vocational applications, construction, some of the refuse, et cetera, where we, we have a position in Europe. You know, one of our larger Germanic OEMs has indicated that, that their volume is going to be down 25% for the year, relative to the reduced level of business. So that would be kind of my, my high-level summary of the, the, around, what we call our European, Middle East, Africa region.
Thomas Robyn (Equity Research Analyst)
Okay, great. Thanks. And then, can you just give a little bit of color on where you are with the TC10 and the launch and what the acceptance has been? Some characterization of where volume might be.
Lawrence Dewey (Chairman, President, and CEO)
Sure. Well, as you know, the products offered with Navistar and their ProStar and TranStar models with their MaxxForce 13 engines, you know, we have started to see the deliveries going to customer. We received our largest order to date, 50 units in one swoop here with a particular fleet. So we think we're starting to build some momentum. You know, we've got now 130 customer fleets that have tested the product. A number of them have ordered, others have expressed an interest.
It's a little bit like that, you know, certainly, some of the feedback we've gotten has been kind of like that old Life cereal commercial, where the kids weren't sure they wanted to eat it, and they said, "Let Mikey try it first." And so there are people watching these pilot fleets pretty carefully. And you know, we're confident that that's, that's going to, their experience, as they share that in the industry or as people become aware of it, is going to be a positive one. You know, we continue to work on understanding the fuel efficiency advantage over manuals and AMTs. Frankly, that continues to come back very positive. We would now say you're probably confidently in the range of 5%.
You know, previously, we were talking three or north of that, and we're certainly seeing continued good results in that space. So, you know, it's the ramp, it's that trial phase, it's that, you know, let's see some and make sure we're comfortable with it before we make big purchases. But we think we're finally starting to pick up some momentum there, and we feel good about that.
Thomas Robyn (Equity Research Analyst)
Where are you in picking up any additional OEMs for launching the product?
Lawrence Dewey (Chairman, President, and CEO)
Well, we're in very active dialogue, and have initiatives that we have put forth to expand both the engines that we run behind, as well as the OEMs and their platforms. And I think based on the feedback we had received previously, I think that we are much better positioned relative to getting some progress made on that. We've made some recent offers to some folks to try to get them over the hump.
Thomas Robyn (Equity Research Analyst)
Is that something you think can fall into place here in the second half of the year, or is it a longer selling cycle?
Lawrence Dewey (Chairman, President, and CEO)
You know, I don't think it will result in volume in the second half of the year, because in some cases, there's some engineering integration work that would need to be done that would probably take up the rest of the year. But certainly, we've placed the incentives on the offers such that it would necessitate a fairly aggressive pace, let's put it that way.
Thomas Robyn (Equity Research Analyst)
Okay. And then lastly, just on the military defense side, one of the companies we follow talked about a little bit of uptick in their orders in the quarter. Do you have any sense that your volumes there are stabilizing where they are at all?
Lawrence Dewey (Chairman, President, and CEO)
No, I think that we would continue to say... I mean, it was, you know, we're up compared to the plan, and that's been true in each of the past years. But the plan overall, I mean, the big thing is bringing it down to more normal levels, and what changes that is some timing. You know, we've had people push orders out. We've had people pull them in. You know, we get the spares orders. Those are, you know, virtually impossible to forecast because the folks don't know they're placing them until they do.... So that tends to be, you know, they're not huge numbers, you know, in terms of the base plan, but, you know, it does—when you're dealing with small numbers, a few hundred units is not insignificant on a percentage basis.
But, you know, I would say at this point in time, that you know, we think the plan is prudent. And, you know, anything, if we get some spares orders or, you know, a few additional vehicles drop in, one that we don't have a lot of visibility on, but we're well positioned for, is any time one of the U.S. OEM sells to a foreign government with all the necessary approvals, of course, you know, that's something that we don't have a lot of visibility of, and that rolls in. The beauty of that is, again, those products are variants on our commercial lines with much higher volumes, and we can respond to those orders very quickly.
Thomas Robyn (Equity Research Analyst)
That's wonderful. Thank you very much.
Operator (participant)
Thank you. Our next question comes from the line of Neil Frohnapple with Longbow Research. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Hi, good morning, and congrats on a nice quarter.
Lawrence Dewey (Chairman, President, and CEO)
Thanks.
Thomas Robyn (Equity Research Analyst)
A nice acceleration in North America off-highway revenue during the quarter. Have you really seen an inflection point in new rig order activity? And can we think about that as a new base for the remainder of the year? And I guess just as a follow-up, can you help us understand what a more normalized annual revenue number should look like for this business, since we've seen some widely varying numbers the last few years?
Lawrence Dewey (Chairman, President, and CEO)
Let me talk to the second and then come back to the first. And you know, the off-highway energy business, historically, and you know, we obviously look to say, "Okay, is this how it's going to be going forward, or is it going to stabilize?" I personally think that we're probably entering a period where absent significant shifts in policy, in as much as there's been some export channels opened up, I think you're going to see a more global dampening effect. And I don't mean that in a negative way, I mean, in terms of volatility. That's you know, the world according to Larry Dewey. And you know, obviously, time will tell on that.
Otherwise, you know, under just a regional kind of a basis, historically, here in North America, it's been very, you know, as you know, very cyclical. So it's kind of like saying the average temperature in Moscow is, you know, 72 degrees. The problem is it's 100 in the summer, and it's, you know, minus whatever in the winter. You know, we do think that we've reached an inflection point. We do have, you know, obviously, you can see from the numbers, the transition and the improvement. And frankly, we have inquiries coming in that would suggest that, that, you know, that's going to continue and indeed build on itself, as we talked about with the recovery.
So, you know, we do feel solid on that, and we think that, you know, sometimes, I guess I had a boss who used to say: Sometimes you know, you like to be lucky as well as good. Our timing was, you know, fortuitous relative to the introduction of our new higher horsepower models. It's well positioned in the space, and I think competitively has been well received.
Thomas Robyn (Equity Research Analyst)
Great. That's helpful. North America sales increased 4% on a sequential basis, but you call out lower demand for Highway Series models. Could you just provide a little bit more granularity on this and where the weakness stemmed from, or if it was just more from timing?
Lawrence Dewey (Chairman, President, and CEO)
You know, in terms of when we talk about Highway Series, make sure we're clear, we have a variety of models in the on-highway space, North America. And you know, Rugged Duty Series, for example, goes in refuse trucks and construction, etc. Highway Series is a model that we use, relative to just strictly over the road, pickup and delivery, etc. And so that's the space that we would say hasn't been as strong, although there is even a bright spot in there, in the what we call the metro market, the 3000 HS, again, you know, kind of an over-the-road application, lower torque and horsepower than the TC10 market. For example, the 3000 HS, that's, I think, limited to 1,250 foot-pounds of torque.
But there are some premium mid-range diesels that go into the Class 8 space there, this is the Baby 8, sometimes they're called. So, you know, that's been a good piece for us, whereas the TC10, that's targeted for 1400, 1450 and above, all the way up to 1750 foot pounds. So kind of a bifurcation there of that market.
David Graziosi (EVP, and CFO)
On the seasonality, I think just to add on to Larry's comments, as you know, historically, with our business, when you look at first quarter, second quarter, there's a number of things that add some seasonality to our business, specifically around lease, rental, package delivery, school bus, et cetera. So there's a number of moving pieces. Those will all, for the most part, hit the Highway Series model that Larry referred to. So you just keep that in mind as you think about our volumes in the on-highway business, specifically for North America.
Lawrence Dewey (Chairman, President, and CEO)
Yeah, that's a great point. You know, there was a time when it was even more lopsided. I can recall early on, when I first came to Allison, I mean, you'd see a 60/40 split, maybe in terms of first half versus second half in the on-highway space. In fact, I had the privilege of coming into the plant that was most affected by that, and things were pretty crazy in the second quarter because you had all of the one-way rental fleets. They want their stuff on the road by Memorial Day, because that's the busiest moving weekend of the year, apparently, used to be anyway. So, that's a good add there.
David Graziosi (EVP, and CFO)
Great. Thanks very much. Bye-bye.
Operator (participant)
Thank you. Our next question comes from the line of Vishal Shah with Deutsche Bank. Please proceed with your question.
Lawrence Dewey (Chairman, President, and CEO)
Good morning.
Operator (participant)
I'm sorry, Mr. Shah disconnected from the queue.
Lawrence Dewey (Chairman, President, and CEO)
Okay.
Operator (participant)
Our next question comes from the line of Larry De Maria with William Blair. Please proceed.
Thomas Robyn (Equity Research Analyst)
Hi, good morning. Thank you.
Hi.
I'm just curious about just some of the potential moving parts in the market, and how do we think about, you know, Ford's decision to potentially insource its transmissions in the future? How would... What kind of impact do we think about that, and when would you expect that to run through the P&L? And secondly, within the quarter, and more broadly, have you seen any impact from AMT in straight trucks, any kind of share shift? But from what we see, obviously, you should have been pretty resilient. Is that a fair comment?
Lawrence Dewey (Chairman, President, and CEO)
The second question first. We certainly, if anything, we think we're, we're, those that I would say that the, the shift, at least in our addressable markets, relative to AMTs, we feel we're well positioned. In fact, we think that, probably some who have, tried the product have seen, some of the performance attributes, and, and if anything, we think that, we've, we've gotten some of that back from, from folks that, that tried some. The, relative to the, Ford, the Ford announcement, certainly, you know, we an- we anticipated that. What they're trying to do is take a, a variant of their automotive transmission.
You know, they, they have integrated that transmission with their, their engine family, you know, for the automotive side, and so they don't have, you know, they've got the engineering work done, and, and they're attempting to go with a, obviously, a vertically integrated solution. In addition to the Allison, they've also deleted the Cummins engine, which, as you know, is, is the most popular, offering in the medium duty space. So they're clearly, you know, essentially, they're—if you summarize their strategy, it's we're going to attempt to offer a vehicle which may not have all of the commercial duty attributes, at a lower price point. And so we have already begun working.
In fact, the week that they announced it, at the show here, we also did an announcement with Freightliner on a program, and we are working with other OEMs. They are going to Ford now, that's gonna be effective here the end of the first quarter of 2015, I believe, is the timing on that. We've already begun working with end users, who have been very pleased with the Allison, working with the alternate OEMs to attempt to see if we can't put together programs, that would allow them to move. It would be a conquest sale, for the other OEM, and it would be a maintenance of the business that we've gained, for Allison. And so that's-- that's kind of the path we're on.
We have a fairly aggressive marketing campaign, which is taking the differences in the products. We have a competitive analysis group that does tear downs, and we've done some of that work, and we'll be sharing that with end users to demonstrate the difference. And for those that are, you know, looking for the kind of commercial duty durability, you know, we think that the Allison offering is gonna be pretty appealing, particularly, as we work with the other OEMs to come up with an interesting total vehicle package offering.
Thomas Robyn (Equity Research Analyst)
Okay, that's great. Thanks very much for that color. And then secondly, on the cash flow, seems potentially conservative to us on the full year basis because we're, if we look at run rate and the CapEx and the cash taxes, is there a reason why they might step up in the second half? Or, are we thinking correctly that there could be some conservatism on the cash flow?
David Graziosi (EVP, and CFO)
Yeah, on the cash flow taxes, historically, have been more—cash taxes have been more weighted to the second half of the year, just around the filing, return filing timelines, et cetera, and the estimated payment. So, you will necessarily see a higher level, typically in the second half. There's a number of moving pieces that obviously, we've assumed, in the cash flow forecast. One of the bigger drivers that, you need to, pay attention to is the U.S. government price reduction payments and the sequencing there. As you'll note, when we filed the, Q, when you look at the breakdown of current liabilities, there's, you know, a $20+ million obligation that's sitting there as current. That's a significant driver in terms of our assumptions around, cash flow for the second half, certainly.
Again, we have no control over the sequencing there and the timing. So, to your comment then on the conservatism or otherwise, you know, I would certainly say we provide the guidance we feel is certainly attainable. As we get further into the second half here, we'll update for the third quarter, but we're, you know, we're certainly pleased with the development of cash flow so far this year.
Thomas Robyn (Equity Research Analyst)
Okay, understood. Thanks very much.
David Graziosi (EVP, and CFO)
You're welcome.
Operator (participant)
Thank you. Our next question comes from the line of Alex Potter with Piper Jaffray. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Hi, guys, thanks. You had mentioned a little earlier about a change in, I guess, your organizational structure in China or something, to try to address the lower-than-expected penetration in the truck market. Was wondering if you could elaborate a little bit on what exactly you've changed there, and when you might think you could see some results?
Lawrence Dewey (Chairman, President, and CEO)
We brought in some mid-management leadership that has a better proven track record of delivering on increasing and at the end user level, in particular, more demonstrated capability in selling the end user. We've got the releases, as we've talked about in the past, and now you know, you secure the release, you promote the release through the OEM, and you sell the end user. And we've certainly done the first. We need to continue to iterate on the second point, and the third point is really where I would say that we need to step up our efforts.
And so we have changed some re-reporting structures to separate the bus from the truck more completely, have brought on some additional resource in the truck space to go after the end users, and have brought in a more proven managerial leadership in that space.
Thomas Robyn (Equity Research Analyst)
Okay, very good. That's helpful. You also mentioned here recently, this 5% fuel economy benefit of the TC10 versus manuals and AMTs. Is that—What is it versus manuals, and what is it versus AMTs, or do you just kind of use a blended number?
Lawrence Dewey (Chairman, President, and CEO)
Well, really, frankly, depending on the duty cycle, you'll actually get a flip over between the two of them, so we tend to use a blended number. Obviously, what we want to do is we want to get the customer to try it in their specific application and see what they're getting. I mean, we've got folks with numbers that approach 10%. We've got folks with numbers that are 2%. You know, obviously, the higher, the shorter the payback.
Thomas Robyn (Equity Research Analyst)
Okay, good. Thanks, guys.
Lawrence Dewey (Chairman, President, and CEO)
Yep.
Operator (participant)
Thank you. Our next question comes from the line of Nicole DeBlase with Morgan Stanley. Please proceed with your question.
Thomas Robyn (Equity Research Analyst)
Hi, guys. This is Thomas Robyn for Nicole. I just have a couple final tie-up questions. On the $16 million of deferred revenue in the defense segment, is there any EBITDA in, with that?
David Graziosi (EVP, and CFO)
Sure. Obviously, the EBITDA is recognized when the sale is recognized, so the deferred revenue brings with it the associated EBITDA.
Thomas Robyn (Equity Research Analyst)
Okay, great, thanks. And then on the just a little bit on margins, how should we think about the sequential changes between 2Q and 3Q and 3Q and 4Q? And are you guys anticipating any major differences between, I guess, the second half and normal seasonality?
David Graziosi (EVP, and CFO)
Well, yeah, we do have some seasonality. Historically, the fourth quarter features about 5% less workdays because of the holidays, as you would expect there. But that has some impact on our fourth quarter results historically, and I don't believe this year will be different. From an overall standpoint, as I mentioned, we do have some initiative spending teed up for the second half around both product engineering as well as our SG&A. Again, the seasonality is applicable there as well, more so on the product initiatives timing, frankly. So, but you will see that roll through relative to our guidance. But beyond that, there's really nothing that significantly different from first half, second half.
Thomas Robyn (Equity Research Analyst)
Great. Thanks, guys. That's all I have.
David Graziosi (EVP, and CFO)
Thank you.
Operator (participant)
Thank you. Our next question comes from the line of Tim Thein with Citigroup. Please proceed with your question.
Timothy Thein (Analyst)
Great, thanks. We'll just squeeze these two quick ones in, if I may. The first, Larry, on the global supply chain, you referenced this earlier. Just wanted to come back and see actually where you stand in terms of the utilization, in both Hungary as well as, I guess, what's a relatively new facility in India. I'm just curious, how much, you know, you've been able to push over there, especially in light of what looks like a, maybe a little softer kind of international sales backdrop. So maybe just some help there.
Lawrence Dewey (Chairman, President, and CEO)
Yeah, we, one of the things that we have is tremendous scale here in the Indianapolis facility. So actually, it presents a fairly attractive cost picture versus some of the low volume, although we do, for the long term, have confidence that the lower fundamental structural costs in places like Hungary and Chennai will work out. We have not shifted the production locations on anything. In terms of utilization, we're running one shift in Hungary, virtually one shift, full, give or take. And in India, we're on one shift, but we're probably not full on the one shift, so we've got considerable runway there. The other thing we're doing, particularly with India, is using that as the base.
We've connected our operations and our purchasing groups to increase our capability there globally. We've done that in terms of our structure, reporting up even through me. And we're using the India facility and that technical expertise that we have invested in there to help us further our global purchasing footprint, particularly in Asia. So that's where we would expect some gains to be made, and you know we'll. You know it looks promising, but you know we'll wait until we've got you know the fish landed and in the net before we declare victory there.
Timothy Thein (Analyst)
Okay. Then just lastly, could we maybe come back to the initial, you know, the kind of 4%-6% revenue guidance range versus, you know, the initial forecast, and obviously, the components have shifted intuitively, given presumably higher weighting towards North America and less international. But it may be just a little bit more granularity in terms of that, you know, 30% growth in the North America energy piece. Even if you don't want to give us a point estimate, can you just kind of give us some help? You mentioned that you had some of the inquiry levels that came through in the second quarter. So maybe just how we should be thinking about that business for the second half.
David Graziosi (EVP, and CFO)
Sure. To Larry's earlier comments, as we think about it, and the ramp rate significant, that has certainly been in the first half as we think about the second half and reaching some, I would say, interim point of critical mass in that market. When you compare first half to second half, we certainly expect second half to be up sequentially, I would say, you know, in a meaningful way. Having said that, we're still, you know, well below, when you look at it on a full year basis, still well below the 2011, 2012 peak levels. But our, you know, forecast, again, is based on feedback from end users and a multiple source, if you will, there.
To Larry's earlier comments as well, I think the volatility speaks for itself, so we're not gonna get, you know, over our skis on this at this point. I think there's a number of things that we need to see develop in the second half and continuing to see support at the, at the molecule level. And, you know, frankly, I think some of the things that are going on outside North America as well, when you think about the global view and what's happening there, and whether we're gonna see more equipment being sourced out of North America for Asia and some other areas, remains to be seen. So it's something we're paying a fair bit of attention to.
The service, the aftermarket piece of that, though, is relevant when you look at the development of Q2 year-over-year, it's up about $9 million, which is obviously significant, or $3 million sequentially. So again, as we think of that piece as a leading indicator, it, it certainly is a healthy increase. Having said that, to Larry's earlier comments, we would expect more or less second half to be relatively consistent with the first half there.
Timothy Thein (Analyst)
Very helpful. Thank you.
Lawrence Dewey (Chairman, President, and CEO)
Okay. Well, I'd like to thank those on the call this morning. We appreciate the interest. We'll speak again next quarter. Good day.
Operator (participant)
Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.
