Allison Transmission - Q3 2015
October 27, 2015
Transcript
Operator (participant)
Welcome to Allison Transmission's third quarter 2015 results 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 Transmission will conduct a question-and-answer session. Conference call participants will be given instructions at that time. As a reminder, this conference 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 third quarter 2015 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, 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 November 3. As shown on page two of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These forward-looking statements are subject to known and unknown risks, including those set forth in our third quarter 2015 results press release and our annual report on Form 10-K for the year ended December 31, 2014, 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 three of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached as an appendix to the presentation and to our third quarter 2015 results press release. Today's call is set to end at 9:00 A.M. Eastern Time. In order to maximize participation opportunities on the call, we'll take one question from each analyst. Now I'll turn the call over to Larry Dewey.
Larry Dewey (Chairman, President, and CEO)
Thank you, Dave. Good morning, and thanks, everyone, for joining us today. Allison's third quarter 2015 results are within the full year guidance ranges we provided to the market on July 27th. Net sales in the North America on-highway end market improved on a year-over-year basis for the ninth consecutive quarter. The year-over-year reductions in the global off-highway and service parts, support equipment, and other end markets net sales are consistent with the previously contemplated impact of lower energy and commodity prices. Despite challenging conditions in the global off-highway end markets, Allison demonstrated strong operating margins and free cash flow and disciplined capital allocation, while closely aligning costs and programs across its business with current end market conditions and our strategic priorities.
Examples of cost alignment and opportunities prioritization during the third quarter include the introduction of several new bus and coach transmission models, featuring our latest product enhancements and fuel efficiency technology, end-user field testing of Allison's new 3,200-horsepower pressure pumping transmission model, and Navistar's ProStar model release of the TC10 transmission with the Cummins ISX15 engine. Please turn to slide four of the presentation for the call agenda. On today's call, I'll provide you with an overview of our third quarter performance, including sales by end market. Dave will review the third quarter financial performance, including adjusted EBITDA and adjusted free cash flow. I'll wrap up the prepared comments with the full year 2015 guidance update prior to Q&A. Please turn to slide five of the presentation for the Q3 2015 performance summary.
Sales decreased 11% from the same period in 2014, principally driven by lower demand in the global off-highway end market, partially offset by higher demand in the North America on-highway end market and price increases on certain products. Gross margin for the quarter was 47.9%, an increase of 100 basis points from a gross margin of 46.9% for the same period in 2014, principally driven by price increases on certain products and favorable material costs. Adjusted net income decreased $15 million from the same period in 2014, principally driven by decreased sales volume and unfavorable product warranty adjustments, partially offset by price increases on certain products, favorable material costs, lower incentive and stock-based compensation expense, reduced global commercial spending activities, and decreased cash interest expense.
Please turn to slide six of the presentation for the Q3 2015 sales performance summary. North America on-highway end market net sales were up 2% from the same period in 2014, principally driven by higher demand for Highway Series models. North America hybrid propulsion systems for transit bus end market net sales were down 48% from the same period in 2014, principally driven by lower demand due to engine emissions improvements and non-hybrid alternatives that generally require a fully automatic transmission. North America off-highway end market net sales were down 60% from the same period in 2014, principally driven by lower demand from hydraulic fracturing applications.
Defense end market net sales were down 3% from the same period in 2014, principally driven by reductions in U.S. defense spending to longer-term averages experienced during periods without active conflicts. Outside North America on-highway, end market net sales were down 8% from the same period in 2014, principally driven by lower demand in China, partially offset by higher demand in Europe. Outside North America off-highway, end market net sales were down 78% from the same period in 2014, principally driven by lower demand in the energy sector. Service parts, support equipment, and other end market net sales were down 14% from the same period in 2014, principally driven by lower demand for North America service parts. Now, I'll turn the call back over to Dave Graziosi.
David Graziosi (EVP and CFO)
Thank you, Larry. Please turn to slide seven of the presentation for the Q3 2015 financial performance summary. Given Larry's comments, I'll focus on other income statement line items and Adjusted EBITDA. Selling, general and administrative expenses decreased $1 million from the same period in 2014, principally driven by lower incentive and stock-based compensation expense and reduced global commercial spending activities, partially offset by $7 million of unfavorable product warranty adjustments, largely attributed to specific field action programs. Engineering, research, and development expenses decreased $1 million from the same period in 2014, principally driven by lower incentive compensation expense. During the third quarter of 2015, the Environmental Protection Agency determined that General Motors' environmental remediation activities at our Indianapolis, Indiana, manufacturing facilities pursuant to the 2007 asset purchase agreement were complete, resulting in Allison assuming responsibility for future operating, monitoring, and maintenance activities.
Given the EPA's finding, we recorded a pre-tax charge of $14 million for the environmental remediation future activities liability in our third quarter 2015 results. Interest expense net increased $4 million from the same period in 2014, principally driven by $15 million of unfavorable mark-to-market adjustments for our interest rate derivatives, partially offset by debt repayments and refinancing, and the August 2014 expiration of certain LIBOR swaps. Cash interest expense decreased $13 million from the same period in 2014, principally driven by the August 2014 expiration of certain LIBOR swaps and debt repayments and refinancing. Income tax expense for the third quarter of 2015 was $27 million, resulting in an effective tax rate of 37% versus an effective tax rate of 41% for the same period in 2014.
The decrease in the effective rate is principally driven by the change in discrete activity. Diluted earnings per share for the quarter was $0.32, excluding the after-tax impact of the environmental remediation charge. Mark-to-market adjustments for our interest rate derivatives reduced the diluted earnings per share for the quarter by $0.03. Adjusted EBITDA for the quarter was $174 million, or 35.3% of net sales, compared to $202 million, or 36.5% of net sales for the same period in 2014. The decrease in Adjusted EBITDA was principally driven by decreased sales volume and unfavorable product warranty adjustments, partially offset by price increases on certain products, favorable material costs, lower incentive compensation expense, and reduced global commercial spending activities. Please turn to slide 8 of the presentation for the Q3 2015 cash flow performance summary.
Net cash provided by operating activities decreased $18 million from the same period in 2014, principally driven by decreased sales volume, partially offset by price increases on certain products, favorable material costs, reduced global commercial spending activities, decreased cash interest expense, and reduced excess tax benefit from stock-based compensation. Adjusted Free Cash Flow decreased $22 million from the same period in 2014, principally driven by decreased net cash provided by operating activities and reduced excess tax benefit from stock-based compensation. During the third quarter, Allison continued its prudent and well-defined approach to capital allocation by settling $181 million of share repurchases, paying a dividend of $0.15 per share, and repaying $6 million of debt.
Our share repurchases for the nine-month period ended September 30, 2015, were approximately 10 million shares, or 5.6% of the issued and outstanding shares as of December 31, 2014. We ended the quarter with net leverage of 3.08, $148 million of cash, and $455 million of revolver availability. Now I'll turn the call back over to Larry Dewey.
Larry Dewey (Chairman, President, and CEO)
Thanks, Dave. Please turn to slide nine of the presentation for the full year 2015 guidance update. We anticipate no meaningful relief from the global off-highway end market challenges in the fourth quarter and are affirming our full year guidance ranges, specifically a net sales decrease of 6%-8% year-over-year, an adjusted EBITDA margin of 34.75%-35.75%, adjusted free cash flow of $470 million-$500 million, capital expenditures of $60 million-$70 million, and cash income taxes of $10 million-$15 million. Although we are not providing specific fourth quarter 2015 guidance, Allison does expect fourth quarter net sales to be lower than the same period in 2014.
The anticipated year-over-year decrease in fourth quarter net sales is expected to occur due to lower demand in the global off-highway and defense end markets. This concludes our prepared remarks. 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 star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would 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 star key. To allow for as many questions as possible, we ask that you limit yourself to one question before passing the floor. Our first question comes from the line of David Leiker with Robert W. Baird. Please proceed with your question.
David Leiker (Analyst)
Hi, good morning, everyone.
Larry Dewey (Chairman, President, and CEO)
Morning, Dave.
David Leiker (Analyst)
If we look at the actions that you've taken here in the quarter, on the cost side, and maybe it's better to look across the whole year, but are there some metrics you can give us in terms of where you are in capacity utilization or change in headcount or, you know, temporary versus full-time workers or anything along those lines?
Larry Dewey (Chairman, President, and CEO)
Sure. You know, we anticipated a fairly choppy horizon. So what we did when we saw some of the positive numbers rolling in, we opted not to do a lot of hiring. Frankly, some of our factories, while we were operating on a little more than one shift, we added Saturdays in where demand looked like it was increasing a little bit so that we didn't create a cost overhang. And as we've seen, a little bit of the orders stabilizing and not continuing to increase, we weren't in a position where we had to do significant reductions. We just rolled the overtime out of the schedule.
Okay, great. I'll adhere to the one question rule. Thanks.
Thanks.
Operator (participant)
Thank you. Our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.
Larry Dewey (Chairman, President, and CEO)
Morning, Jerry.
Operator (participant)
Mr. Revich, perhaps your line is on mute.
Larry Dewey (Chairman, President, and CEO)
Jerry?
Operator (participant)
I'm sorry about that. Our next question comes from the line of Jamie Cook with Credit Suisse. Please proceed with your question.
Jamie Cook (Managing Director)
Hi, good morning.
Larry Dewey (Chairman, President, and CEO)
Hey.
Jamie Cook (Managing Director)
Can you just talk about, you know, how you're thinking about over the next 12 months, your outlook on the defense business, in particular? You know, JLTV got awarded, which I would guess would impact you longer term, but then there's also talk of, international M-ATV awards that it's supposed to get, you know, awarded probably by the end of the calendar year. So just, wondering how you're thinking about that and the potential upside to you guys. Thanks.
Larry Dewey (Chairman, President, and CEO)
Sure. Well, you're correct to note that there's a number of programs that are being discussed out there. We've got the ones that Oshkosh announced for the FMTV plus-up and the foreign, or non-US M-ATV sales that they announced in Q2, Q3. We've got those rolled in. Obviously, we continue to work closely with our defense OEMs, wheeled OEMs, as well as some of the folks on some track programs. As those are secured, we roll those in immediately to the forecast. Obviously, some of the others are a bit more speculative at this point. You know, we think we're well positioned relative to the forecast.
We will be coming out in early 2016 with our fourth quarter 2015 call to give a specific view as to what we see in that space for 2016. But, you know, clearly, we're coming off a relatively low base with the US Army and adding to it with some of these non-US orders.
Jamie Cook (Managing Director)
But I know you talked about the FMTV and then the international M-ATVs that they've talked about so far, but I guess there's the view that there's an opportunity for a significant amount more of international M-ATVs. Is that something that you think we should think about as we think about modeling for 2016? Or do you still think that's sort of the timing would still be uncertain with that?
Larry Dewey (Chairman, President, and CEO)
Well, you know, certainly, you have a probability on any given one of those. I would say, as you've seen in our numbers to date, with some of the geopolitical developments, there has been an increase in defense procurements, particularly in the wheeled space. You see that in our Europe numbers, some of the Middle East numbers, as well, and so, even a little bit in Asia, but mostly in Europe and Middle East. And so we would expect that kind of backdrop to continue, I guess, is the way I'd say it, and I'd probably look at all the programs and handicap them a bit and then come up with an expected value. That's kind of how we think about it.
Jamie Cook (Managing Director)
All righty. Thanks. I'll get back in queue.
Operator (participant)
Thank you. Our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.
Jerry Revich (Senior Investment Leader)
Hi, good morning.
Larry Dewey (Chairman, President, and CEO)
Morning, Jerry. I thought I was gonna have to do, like, a mind meld there for a second.
Jerry Revich (Senior Investment Leader)
Sorry about that.
Larry Dewey (Chairman, President, and CEO)
Sorry.
Jerry Revich (Senior Investment Leader)
I'm wondering if you could just talk about market share developments over the course of the quarter as you see it on the order book. Obviously, Ford has had no impact on your business. Doesn't look like there's been any impact on the Eaton side, and I know you've been focused on conquest customers as well. Can you just give us an update on those three areas and what the order book tells you about what the market share outlook is over the next couple of quarters?
Larry Dewey (Chairman, President, and CEO)
Sure. You know, the areas that probably look like the brightest spots here in North America are the Class 6-7 truck, where, if you look at the industry numbers versus our numbers, now you always got to be a little careful to make sure you're looking at, production versus sales, because, of course, we're tied into the production. But if you take a look at that, we feel good, about some of the gains we've made. If you look at the industry data versus our data, would appear that, that our numbers are, are higher than the industry.
The same thing is true for Class 8 straight truck and even in the metro, although we're coming off a pretty low base there. You know, we're able to pick some up. So if you take a look, like I say, the way I'd run that number is I'd run the industry and then run our data, and I think what you'll see is our numbers are above the industry, have been through 2014 and even 2015. So, you know, we've obviously. ACT publishes the data, finalizes the actuals a little bit after the time period, but we would expect to see some gains in those spaces in particular.
Rob Wertheimer (Senior Industrials Analyst)
And the order book tells you that's going to continue over the next couple of quarters?
Larry Dewey (Chairman, President, and CEO)
Well, you know, the order books, as you know, are moving around a bit. You know, we've got some folks that are adding line rates, but we do have some other folks that are putting in a little more downtime. I'm sure you guys look across the industry and see that as well. So those are moving around a bit, but within those movements, we would see those trends continuing.
Rob Wertheimer (Senior Industrials Analyst)
Okay. Thank you.
Larry Dewey (Chairman, President, and CEO)
Welcome.
Operator (participant)
Thank you. Our next question comes from the line of Nicole DeBlase with Morgan Stanley. Please proceed with your question.
Nicole DeBlase (Executive Director)
Yeah, good morning, guys.
Larry Dewey (Chairman, President, and CEO)
Morning.
Nicole DeBlase (Executive Director)
So, my question is around the North America off-highway business. We have to get to that one, obviously. Can you just comment a bit on what you're hearing from energy customers in North America? And I guess my specific question is: do you think that the quarterly run rate of North America off-highway revenue has bottomed, or could there be further sequential downside in the fourth quarter?
Larry Dewey (Chairman, President, and CEO)
You know, from where we sit, you know, looking at the fourth quarter, it's, you know, fundamentally, you're at a pretty low base in Q3. You know, we'd see just a tinge of a down. I mean, we're essentially at the bottom. And the issue is, when is it going to turn? And as it stands right now, when you're looking at a lot of the data we're looking at, you know, we're certainly not going to get out ahead of ourselves. We think that the current dynamics are such that the off-highway is in a position, the energy, and I'm speaking specifically, that's probably going to be in place for a while. And so we would expect that we'll bump along where we're at.
And then, you know, what we're working on in our forward forecasts that we'll be updating, like I say, next quarter call, would be when, when do we think the turn is going to occur? And, you know, there's a lot of opinions on that. We tend to be, you know, we tend to like to see it before we call it, so, so you can count on us to be, to make sure again, that we don't get out ahead of ourselves on that.
Nicole DeBlase (Executive Director)
Okay, that's really helpful. Thanks. I'll pass it on.
Operator (participant)
Thank you. Our next question comes from the line of Robert Wertheimer with Barclays. Please proceed with your question.
Rob Wertheimer (Senior Industrials Analyst)
Hey, good morning, everybody.
Larry Dewey (Chairman, President, and CEO)
Morning.
Rob Wertheimer (Senior Industrials Analyst)
So I guess medium-duty orders have been a little bit mixed, but pretty good. Class 8 vocational or straight has been a little bit softer. And at least in our view, both of those fleets are relatively old, and so the setup should be okay. I'm wondering, given the detail you can see into it, what is the issue with Class 8 straight? Is it just that order boards were full and people didn't want to order? Is it mostly Canada? Is it mostly, you know, oil? Or maybe you can give us some sort of help there.
Larry Dewey (Chairman, President, and CEO)
Well, there's certainly, there's certainly, a fair amount of support vehicles that go into supporting the off-highway that would be classified under, straight truck, Class 8. You know, if you take a look, the interesting thing is, if you take a look at, the ACT data for the North America Class 8 straight truck inventory to retail sales ratio, you know, it's been bumping along within the kind of the three to four month range. It's actually—it's in the higher end of the range, but it has been a little higher, historically, depending on which month. You got to be careful because some of the months, jump the data around. But it is above the average there. So we see some people taking, some of the inventory down.
We do expect, depending on the OEM, some activity. There's going to be the construction pickup here starting in the fourth quarter into the first quarter. Some of the municipalities, you know, if they're operating on a calendar year budget, and if they have not spent their money, you know, it's kind of spend it or lose it. So, you know, we're watching that pretty closely as well. But, you know, we think the overall assessment that you've noted relative to the age of the fleets in many cases is correct. You know, the issue is, how is that going to play out specifically in terms of timing?
Rob Wertheimer (Senior Industrials Analyst)
Okay, great. I'll circle back again. Thank you.
Larry Dewey (Chairman, President, and CEO)
Yep.
Operator (participant)
Thank you. Our next question comes from the line of Ian Zaffino with Oppenheimer. Please proceed with your question.
Ian Zaffino (Managing Director)
Hi, thank you. Just a quick question on the use of cash flow. Is that going to go now all towards buybacks, or how do you think about some of your debt maturities and the balance sheet?
David Graziosi (EVP and CFO)
Sure. You look at the debt maturities, the only tranche that we have coming up is August of 2017, which is the Term Loan B-2.
Larry Dewey (Chairman, President, and CEO)
It's about $190 million outstanding. So, as we've discussed the capital allocation model in our policies, we'll execute against the $500 million authorization that we have. We talked about the progress to date here, roughly $296 million executed, continue to use the medium term net leverage target of 3x-3.5x. And then, of course, the $0.15 per share per quarter dividend. So, we continue to move consistent with that policy and allocation, and obviously would, as Larry said, as we get to the fourth quarter results call and provide 2016 guidance, we'll provide an update at that point if there are to be any changes.
But I would certainly describe our position on the share repurchases as continuing to be opportunistic.
Ian Zaffino (Managing Director)
Okay, perfect. Thank you very much, guys.
Operator (participant)
Thank you. Our next question comes from the line of Anne Duignan with JPMorgan. Please proceed with your question.
Ann Duignan (Managing Director and Equity Research Analyst)
Yeah. Hi, good morning.
Larry Dewey (Chairman, President, and CEO)
Good morning.
Ann Duignan (Managing Director and Equity Research Analyst)
Can you just give us a little bit more color on the warranty costs or the warranty issues that you talked about in the quarter?
Larry Dewey (Chairman, President, and CEO)
Sure. On one of our medium duty products, we've got a situation where we've identified the possibility of some issues tied back to some torque converter backing plate bolts bolt issues. And so we've taken a very aggressive posture consistent with the Allison brand promise, to go get those units before customers could or would have an issue. We've got a pretty wide net that we've cast relative to making sure that we get every one of those so that we don't take the chance of them having unscheduled downtime. So we're taking a very aggressive posture to again support the customer so that they don't have unscheduled downtime unnecessarily.
Ann Duignan (Managing Director and Equity Research Analyst)
And so that was mostly a Q3 cost and a Q3 event, or will that spill into Q4 in 2016?
Larry Dewey (Chairman, President, and CEO)
No, no. We operate when we identify the issue. We accrue the full amount that we anticipate for the expense.
Ann Duignan (Managing Director and Equity Research Analyst)
Okay. And then just circling back to an earlier question on your market shares, you did a wonderful job of not telling us your market shares. Could you give us your market share specifically? I know it's market share of production, that's fine. But on Class 6, 7, and Class 8 straight, what is your market share year to date?
Larry Dewey (Chairman, President, and CEO)
Again, we wait for the final numbers to nail that down, but you're probably right, say, 74%-75% on Class 6-7 truck, and we're north of the 56% on the Class 8 straight truck.
Ann Duignan (Managing Director and Equity Research Analyst)
Okay, great. Thank you. I'll get back in line.
Larry Dewey (Chairman, President, and CEO)
Yep.
Operator (participant)
Thank you. Our next question comes from the line of Larry DeMaria with William Blair. Please proceed with your question.
Larry DeMaria (Group Head of Global Industrial Infrastructure)
Hi, thanks. Good morning. You guys recently got a new order for the TC10. Can you maybe put the importance of that in perspective? Does that, you know, does it, number one, move the needle? And then secondly, are we getting any closer, getting more OEMs signed up for the TC10? Just curious about the adoption and, you know, if you could put it all in perspective for us. Thank you.
Larry Dewey (Chairman, President, and CEO)
Sure. Well, MVT, the very large order that they recently placed is a repeat order. They are a, I think, considered a leading, leading fleet relative to fuel efficiency. And so, you know, that's a significant endorsement. They had a relatively significant order, I think it was about 50 units initially. And then, of course, with the recent announcements, they made a very, very significant purchase there. You know, it's important to note that, you know, we've got a number of repeat orders, including another one that, that will probably be getting announced here pretty soon. Not quite as large as the MVT, MVT order, but, but certainly, you know, very significant.
You know, we've had, we've had 146 different fleets purchase the TC10, typically in small quantities, as they, as they test it. Having said that, 19 of those have already placed repeat orders. As you may have also noted, Navistar, as I mentioned in my remarks, will be releasing the TC10 behind the Cummins ISX 15-liter engine. And we're certainly actively engaged with other OEMs and are hopeful, I guess, optimistic that we'll have more developments to announce here as we go forward.
Larry DeMaria (Group Head of Global Industrial Infrastructure)
Thanks. So just, I mean, is the issue that we need, you know, a history of fuel economy savings, or is it the residual value?
Larry Dewey (Chairman, President, and CEO)
Well, residual value is yet to be proven out. We're confident that it's gonna carry the same kind of residual value benefit that the Allison has typically had. But absent a multi-year experience, we certainly aren't getting that credit yet at this point in time. It really becomes a question of productivity and the fuel efficiency of the product.
Larry DeMaria (Group Head of Global Industrial Infrastructure)
Got it. Thank you.
Larry Dewey (Chairman, President, and CEO)
Yes, you're welcome.
Operator (participant)
Thank you. Our next question comes from the line of Ross Gilardi with Bank of America Merrill Lynch. Please proceed with your question.
Ross Gilardi (Managing Director)
Morning. Thank you.
Larry Dewey (Chairman, President, and CEO)
Morning.
David Graziosi (EVP and CFO)
Morning.
Ross Gilardi (Managing Director)
Just a question on pricing. I mean, you got some pricing this year at the same time that costs are going down, and clearly, you've seen, you know, some nice margin expansion on that. Just wondering, do you feel like the price gains that you've achieved in 2015 are sustainable for 2016, and then what's the outlook for additional price increases next year, particularly given the, you know, downdraft in costs and sort of mixed demand environment?
David Graziosi (EVP and CFO)
We'll have some additional price in the fourth quarter on a year-over-year basis. As we enter 2016, we would expect some additional activity on that front. As we've said many times, we continue to invest in the product and frankly, the value that it's delivering to end users. So, you know, that has been and continues to be a focus for our team. At the same time, we're gonna drive forward our growth initiatives outside of North America in a number of areas, as well as continue to support, despite the challenging market conditions, some of our new products, including the higher horsepower frac transmission that Larry mentioned. So, all of that is in the mix.
As we've said, margin improvement relative to the total view here, we will invest some of that again in growth initiatives outside of North America, of course, and then, you know, look to making some continued improvements in our supply chain side as well. On the labor side, Larry mentioned the fact that we continue to manage output through largely overtime in the on-highway plants. We continue to use that process given the broader market conditions that we face.
Ross Gilardi (Managing Director)
Thanks, Dave. And then just looking for a little more color on, you know, the revenue improvement that you saw on the service and parts business. What's behind that? Did that feel sustainable?
David Graziosi (EVP and CFO)
Yeah, we certainly did experience, I would say a bit better volume in a few areas. I would say overall, some of that being tied to, interestingly enough, the off-highway business in North America. Having said that, to some of the earlier questions and Larry's response, we don't necessarily see that continuing into fourth quarter. So, as is usual with us, we take a relatively prudent approach to things. Market conditions, I think you'd be hard-pressed to argue the alternative at this point. If there's, you know, demand there, we're certainly stand ready to fulfill it. At the same time, realistically, given the amount of idled equipment that is out there, we are not expecting, again, a repeat performance in the fourth quarter.
One of the things we are paying a fair amount of attention to broadly is inventory levels throughout the channel, both new units at OEMs as well as distributors. Our posture typically going into the end of the year when market conditions look to be, I would say, a bit more volatile, is to manage our inventories down, and that's a process that we're underway with at this point. So, again, we'll see how things go, obviously, by the end of the quarter and make the appropriate adjustments as we enter 2016.
Ross Gilardi (Managing Director)
Got it. Thank you.
Operator (participant)
Thank you. Our next question comes from the line of Vishal Shah with Deutsche Bank. Please proceed with your question.
Chad Dillard (Senior Analyst)
Hi, this is Chad Dillard on for Vishal. I just want to go back to your comments about material costs. Can you just talk about the magnitude of the benefit that you're seeing and just how to think about when you see these benefits being anniversaried as we move into 2016?
David Graziosi (EVP and CFO)
There's a number of initiatives that the team continues to work on. You know, I would say, you know, in some cases, we're probably at the beginning of that process versus the end. Having said that, we're also focused on supply chain sustainability and resourcing, what I to what I would consider to be longer term positions in negotiating our contracts to reflect that. So this is not, you know, a view that we're gonna have you know, short-term arrangements that dominate our supply chain. Frankly, we take a longer-term view, and we're working against that, at the same time, making investments in value engineering and costing on our components, and making investments in tooling, et cetera.
We expect to achieve some level of return for that, and, and that will be included in the run rates that we'll review with the first quarter guide for 2016. But, you know, we're, we're certainly comfortable from where we're positioned right now in terms of the initiatives that we're pursuing.
Chad Dillard (Senior Analyst)
That's helpful. And then, just for the international on-highway, your, your full year outlook, at least last quarter, was, was flat. Has there been any change to that? And then if, if not, that would imply like a, a rebound in the fourth quarter. So could you just talk about the, the moving parts behind that?
David Graziosi (EVP and CFO)
Yeah, we've, we have not, you know, changed the outlook there. As Larry said, if you look at broader market conditions, and I'm sure you're aware, Asia continues to be more volatile than we'd like to see it. Having said that, as we've also talked about the fact that Europe has been stronger, both on the commercial side, as well as some of the wheeled military activity there. I think that's, you know, net-net has really positioned us to have the overall flat guide, if you will, in terms of no change from the call that we did back in July. So, it's something we're paying a lot of attention to.
Obviously, entering 2016, if there are gonna be any potential improvements, I would say, you know, our broader view right now is the emerging markets will continue to be tough sledding here for some period.
Chad Dillard (Senior Analyst)
Okay. Thank you. I'll hop back in queue.
Operator (participant)
Thank you. Our next question comes from the line of Neil Frohnapple with Longbow Research. Please proceed with your question.
Neil Frohnapple (VP and Senior Research Analyst)
Hi, good morning, guys.
Larry Dewey (Chairman, President, and CEO)
Good morning.
David Graziosi (EVP and CFO)
Good morning.
Neil Frohnapple (VP and Senior Research Analyst)
In the event that overall Class 8 truck in North America is down significantly more than expected in 2016, do you guys still believe that medium-duty truck can decouple and still experience modest growth over the next few years?
Larry Dewey (Chairman, President, and CEO)
I think the short answer to that is, yes. Obviously, there's some overlap. As you correctly point out, there are fleets that run across both of those categories, Class 8 and also 6, 7. But you do see a fair amount of bifurcation in the market there. So the dynamics associated with each, as we've seen, I think are somewhat different.
Neil Frohnapple (VP and Senior Research Analyst)
As a follow-up, I mean, the municipality, are you guys continuing to see increased activity there, and the outlook still seems pretty bright?
Larry Dewey (Chairman, President, and CEO)
Yeah, I mean, it's not, you know, it's, I think, any recovery, as we would note, has been as we have projected going back a couple of years, certainly has not been as extreme, as significant as maybe past recoveries. But, you know, there still seems to be some good solid business and momentum there in the municipalities.
Neil Frohnapple (VP and Senior Research Analyst)
Thank you. I'll pass it on.
Operator (participant)
Thank you. Our next question comes from the line of Joe O'Dea with Vertical Research Partners. Please proceed with your question.
Joe O'Dea (Partner)
Hi, good morning. In North America, on-highway, when you talked about inventory levels in key segments, you know, being maybe just slightly above average, but maybe better than some of the other segments within Class 8. But as you look at build over the last several months, in excess of where order trends have been and a tough comp on strong 4Q orders last year, what is the risk of seeing some downward adjustments in build rates? It doesn't appear that anything like that is contemplated in the guidance, but as you monitor those conditions, do you see the risk of any adjustments within the quarter, just given the build in excess of orders recently?
Larry Dewey (Chairman, President, and CEO)
Well, there's a couple of things. Number one, first off, there are a lot of folks moving around, you know, build rates, scheduled days, scheduled time off. So we have tried to contemplate that in our fourth quarter assessments. I think in the prepared remarks, we noted that we anticipated year-over-year sales to be down in Q4, and I think that captures some of the trends that you correctly point out.
I mean, if you look at, if you look at, Class 6-7 truck inventory to retail sales ratio based on the ACT data, you know, you had a low point in December 2014, you know, outside the system, if you will, between the 2.5-3.5 months that, ACT typically talks about as normal. And if you look at the data points since, there's been a gradual, trend up, and we're starting to see people, react to, to some of that. You know, we-- they, they were obviously anticipating a little different market dynamics, and so we've got, to the extent that, that we're able to ferret that out with the OEMs, we've got that, built into some of our numbers.
In a number of cases, we anticipate, OEMs having to take some volume out based on specific dealer data that we, we gather. So we don't just take the OEM's forecast to us. We, adjust it either upward or downward based on other data that we try to, to get from the market, anecdotal data.
Joe O'Dea (Partner)
Got it. Thank you.
Larry Dewey (Chairman, President, and CEO)
You're welcome.
Operator (participant)
Thank you. Our next question comes from the line of Tim Thein with Citigroup. Please proceed with your question.
Tim Thein (Analyst)
Great. Thank you. Good morning. I just wanted to come back, Dave, to your comments earlier in terms of the outlook for pricing and kind of the value you bring. I'm curious if you're closer to kind of quantifying what the potential benefit from FuelSense could be as it relates to that. And just more broadly, is the, you know, obviously, diesel at $2.50, compared to, you know, a year plus is north of $4. Is there any, you know, and I'm just curious in terms of the overall acceptance or enthusiasm towards that product from your customers in light of the, you know, different fuel price backdrop. Thank you.
David Graziosi (EVP and CFO)
Sure. The FuelSense, understand that there's a number of different technologies that are included in that package, right? So as you think about what we've done, FuelSense has been in the market for a little over a year now from majority of our OEMs. The experience there continues to build with customers. The feedback has been favorable. Larry mentioned some of the things we have done, specifically in transit with some new models there. The experience has been, I think, very favorable for them. If you look at, you know, saving 5%-7% in many cases, plus, which is pretty significant when you think about not changing the space claim of the product or anything that the end user really has to do.
So, that continues to be the focus for us on a number of different technology implementations. FuelSense, broadly, we continue to roll out in that fashion. We would look to make some, I would say that the sort of more complete version of that available here, going into 2017 versus 2016, although we will build upon some of the releases we've already done. But I think the reality is that the valuation, if you will, will be largely determined by end users' experience, and we will, of course, price accordingly. So, it's early days, but I would say the initial returns are certainly, we believe, very positive.
From, you know, the experience that end users have had, including, frankly, the TC10 experience in terms of that product. So, broadly, that's a focus for us. I think fuel, although it's low in terms of commodity price right now, the reality is, if you have a long-term view that it returns to some levels at some point here, our feeling is fleets are not viewing fuel as being cheap for the duration. It will continue to gain, I think, traction there, and more importantly, the reduction in emissions, et cetera, I think broadly is a positive no matter what fleet is, you know, using our products.
Larry Dewey (Chairman, President, and CEO)
Yeah, this is Larry, just tagging on a little bit there. You know, we talk about FuelSense as the umbrella, as Dave has articulated. We've used kind of a varied approach to how we're currently monetizing it. Certainly, the XFE models that I referenced, you know, we're capturing price there. The neutral at stop feature, we're capturing some price. Some of the pure calibration activities, the FuelSense 1.0 as we call it internally here, we're pushing that into the market without price at the current time because we do want the experience. It's kind of, you can think about that like the free samples, if you will.
And people are starting to, more and more OEMs are starting to release that, and the end users are starting to see the benefit. For FuelSense 2.0, and that's what Dave was talking about, in 2017, there will be the next step up, in terms of the benefits that that level of software and calibrations will bring. And it's at that point in time that we'll evaluate the ability to capture incremental price and would anticipate doing it at that time, given people's experience with FuelSense 1.0 and the added benefits of 2.0.
Tim Thein (Analyst)
Got it. Thanks a lot.
Larry Dewey (Chairman, President, and CEO)
Welcome.
Operator (participant)
Thank you. Ladies and gentlemen, as a reminder, if you would like to ask a question, please press star one at this time. Our next question comes from the line of Ted Grace with Susquehanna. Please proceed with your question.
Ted Grace (Research Analyst)
Good morning, gentlemen.
Larry Dewey (Chairman, President, and CEO)
Morning.
Ted Grace (Research Analyst)
I don't know if this is a question for Dave or Larry, but when you go through scenario analysis, could you just walk through how investors should think about kind of a trough EBITDA or EBITDA margin scenario? You know, if we look at 2015, you know, obviously, there are a lot of puts and takes, but you've got favorable price- cost, you know, you've got benefits on incentive comp. You know, you're gonna do EBITDA. It's either the second or third best in the company's history. So I know you haven't given 2016 guidance. I'm not asking for that.
But when you're helping people get their arms around how to think about, you know, a downside scenario, whether that is 2016 or 2017, you know, could you just walk through how you would encourage people to think about that, that analysis?
David Graziosi (EVP and CFO)
Sure. I mean, in terms of downside scenarios, as we said, you know, we'll provide 2016 guidance on the fourth quarter call early next year. When you think about downside, you know, the last downside, if you will, for us certainly was the 2008, 2009 downturn. A number of things have changed in the market. If you look at our largest end market being North America On-Highway, it's difficult for us to frankly contemplate anywhere near that type of market result, frankly. The fleet size, age, et cetera, and all the variables that you're familiar with really make that, I think, an outlier relative to anything that we think about from a planning perspective.
Having said that, if you look at the balance of the end market, certainly outside North America, on-highway continues to be, you know, a growth opportunity for us. Having said that, emerging markets are having their challenges, but broadly speaking, you know, we've seen some softness there that's reflected in our numbers already. Defense, we've talked about, you know, we would certainly expect over the next year or two, that market really bottoming, if you will, from a demand standpoint for a number of reasons. If you look at the balance of our end market, certainly aftermarket parts, et cetera, that's gonna have a strong tie-in to the energy side ultimately, when you think about where that market returns to and ultimately stabilizes at from a longer-term run rate perspective.
So, you know, we are certainly not in a position on the call to be providing, you know, detailed downside scenarios, but I would say within the end markets and the cost structure that we have in place, to Larry's earlier comments, whether it's hourly staffing or even the salaried side and the number of initiatives we have, we have certainly maintained a fair bit of flexibility to adjust our cost structure to market conditions. So, you know, we stand ready to make those adjustments if they're required. At the same time, have continued to invest heavily in growth opportunities and technology implementation.
So we feel very good about the positioning of the product portfolio, and, you know, we'll get after those opportunities that the market provides, but again, stand ready to make adjustments from a cost perspective as they're required.
Ted Grace (Research Analyst)
Okay.
Larry Dewey (Chairman, President, and CEO)
Yeah, I would just, I would just tag on a little bit and say that certainly we feel a lot better about where we stand in the, in the material space. Some of the work that Mike Dick, Teresa van Niekerk have done in the purchasing space, looking out to the contracts that the longer-term contracts that contain the appropriate economics, and what they have done in that space. Certainly, as a result of the previous downturn, we've got a number of structural differences from where we sat going into that, so we feel a little better about that.
You know, we've got, we're finalizing the last of the long-term supply agreements, so, you know, we've got the economics with our customers, our OEM customers, you know, pretty well established, on positive terms. So, you know, there's a number of things that we have in place at this point in time, that position is better. Now, obviously, if something significant changes, we anticipate it and respond to it, but, you know, certainly feel in a very solid position at this point.
Ted Grace (Research Analyst)
Great. And then if I could just—I think at this point, I'm probably one of the last. Could you just bridge us on the 3Q SG&A changes? I know you mentioned lower incentive comp and stock comp and the benefit of lower marketing expense offset by the warranty. But could you give us a specific bridge by category, kind of, you know, how you get to the year-on-year change in SG&A?
David Graziosi (EVP and CFO)
I'm sure if you, you know, go through it, year-over-year, third quarter, incentive comp was about -- and, and, stock-based comp was about $5 million. You had about $7 million going the other direction on the, warranty adjustments, and the balance is just commercial spending.
Ted Grace (Research Analyst)
Okay, great. Thanks a lot. Good luck this quarter, guys.
Operator (participant)
Thank you. Our next question comes from the line of Rhem Wood with BB&T Capital Markets. Please proceed with your question.
Rhem Wood (Analyst)
Hey, good morning.
Larry Dewey (Chairman, President, and CEO)
Good morning.
David Graziosi (EVP and CFO)
Morning.
Rhem Wood (Analyst)
You guys, I guess, reiterated the international on-highway guidance. Can you, are there any changes to the other end markets, or are you reiterating those as well? And then just one more on environmental accrual, that seemed like a Q3 event. It doesn't seem like an issue there, but will any of that carry forward? Thanks.
Larry Dewey (Chairman, President, and CEO)
Let's start with the last part of it first. We believe that we have made the appropriate accrual for the situation I described earlier. You know, we operate from the philosophy, if you've got to eat manure, don't take small bites, you know? So we think we've got it all laid in there, and don't intend to continue to make changes. Obviously, we'll follow that program as we continue to execute the proactive steps that we're taking. But we think we've got it captured. In terms of outside North America, you know, if you look around, you've got... Let's just kind of go around the world quick-like.
You know, Europe, you know, we're starting to see some positive signs, certainly for our business in Western Europe. Some of the activities they've done with natural gas as part of some of the OEMs work there has been real positive for us. You know, Russia's, you know, we were well positioned there, but obviously, with the geopolitical situation, that's been a little choppy. We do have some business in Ukraine, as well as some business with MAZ, one of the former CIS, if you will, OEMs. So that feels pretty solid. We've got some activity in the Middle East. Turkey also has been a plus. You know, Asia, you got some challenges in China. Certainly on the bus side, they're doing some work in pure electric.
We are, you know, working to position ourselves for some of that. I think they're going to have some challenges operationally with that technology, but okay. They're certainly making a run at purchasing some of that product. Truck side, you know, we're continuing to track the plan, feel good about that. India, we've had a nice step up there, both in the bus business as well as some of the work we're doing in the military space, and also the truck space. Japan, solid relative to some of the bus activity and some of the truck, relative to some export programs the Japanese OEMs have there, as well as some inroads into the domestic market, particularly rental and distribution.
Korea's been a bright spot, as we've gotten some of the releases and some of the small bus, truck platforms there. And then, Latin America, you know, it's a relatively smaller part of our business, a mixed bag. You know, the guys have done a nice job of getting some releases with Mercedes in some of the big markets, but, you know, we're, we're a significant presence in the likes of Argentina and Venezuela. Even Brazil is having its challenges economically, and so, so that becomes a bit of a mixed bag. That's kind of one step forward, one, you know, in terms of some of the, the releases and the, the opportunities, and then one step back in terms of some of the underlying economic conditions.
So, that's kind of a little bit of around the world for you.
David Graziosi (EVP and CFO)
Now, I would just add on, in terms of, the guidance and, you know, keeping it flat, again, they're very small changes amongst the seven end markets that we have. But, you know, broadly, the tone there is similar to what we talked about on the July call.
Rhem Wood (Analyst)
Okay, so you're not changing the other, the guidance for the other end markets, is what you're saying?
David Graziosi (EVP and CFO)
Correct. Correct.
Rhem Wood (Analyst)
Okay. Thank you.
Operator (participant)
Thank you. Our next question comes from the line of Alex Potter with Piper Jaffray. Please proceed with your question.
Alex Potter (Senior Research Analyst)
Hi, guys. Just one very quick one here on pricing. I think I heard this correctly, but it sounds like so far, none of the pricing that you're getting is the result of FuelSense, and you're pushing most of that out into the future. Is that right?
Larry Dewey (Chairman, President, and CEO)
That is, on the calibration portion, that is correct. There are some other models, you know, whether it's a neutral at stop or, yeah, neutral at stop feature or the xFE models, we are getting price for those. But the actual calibration portion of the FuelSense program 1.0 is going to the OEMs at this time, at no charge.
Alex Potter (Senior Research Analyst)
Okay, great. Yeah, that's what I thought. And then, I guess just on, you touched on this a little bit with regard to the municipalities, but school bus outlook, what you're thinking there on that one specific, I guess, sub-segment within the municipality market, that'd be helpful? Thanks.
Larry Dewey (Chairman, President, and CEO)
Yeah, that's one that, you know, has been relatively stable. You know, it came down, of course, and we don't see a significant-- We certainly don't see it rebounding to what you might consider a decade-old highs. And we think there's a number of factors that go into play. Fact is, people are holding on to them a little longer. School districts, like so many municipalities, are working with their budgets. And then the other piece of that is, you know, you're seeing a change both in the demographics, schoolchildren situation, as well as the transportation that's used. If you've been by a school, you'll see the school buses there, and then you'll see a line of about 67 cars lined up, and that all equates to reduced demand for the school buses.
They still have to cover the same routes, but they're picking up fewer kids per stop, and so—and the stops are spread out a little further, so they've got a little productivity. They can add a little more distance on it because they're making stops further apart, so they're able to get the route done. So we think that where it sits now is gonna be relatively stable. You're gonna see, you know, a few percent change here and there, but, you know, not anything that gets us back up to I think the peak I saw on some data was 41,000 units. You know, we don't anticipate seeing that.
Alex Potter (Senior Research Analyst)
Okay, very interesting. Thanks.
Larry Dewey (Chairman, President, and CEO)
Yeah.
Operator (participant)
Thank you. Our next question is a follow-up from the line of David Leiker with Robert W. Baird. Please proceed with your question.
David Leiker (Analyst)
Hello again. I just wanted to sneak in here with one more thought. Can you run through where you are on new technology investments? You got a handful of things going on, and I don't think we've talked about it in a bit, but just what you're seeing there and what the outlook looks like for them.
Larry Dewey (Chairman, President, and CEO)
Sure. There's a number of things, you know, we're working on. In the off-highway space, we continue to look at the horsepower capability and continue to add to that on the high end. You know, we think that there's certain dynamics in certain parts of the world that are gonna drive towards higher horsepower, fewer rigs, more horsepower per rig, such that you can bring the same amount of horsepower to the well. The pad with the, you know, multi-well kind of scenario lends itself to that also. So we continue with that, product development activity in the off-highway space. In the on-highway space, in addition to some of the FuelSense work we're doing, some of the hybrid and electrification work that we're doing, where we're taking existing...
The work we're doing involves our 3000 Series platform, where we think, subject to battery capability, and that's always the big issue with electric vehicles. But subject to that, we think we've got a concept that may have some interest to customers, and we're continuing to work on that development. Then, of course, the Fallbrook and the Torotrak, continuing to work the three-legged stool challenges there with both of those technologies for IVT, CVT kind of application as main transmission products. The three legs being performance, that is, primarily fuel efficiency, although there are some other features that are enabled, some capabilities that are enabled by those technologies.
But fuel efficiency, durability, and packaging, and we continue to try to bring all three of those into a workable solution for OEMs and end users, and that work continues today.
David Leiker (Analyst)
Okay, great. Thank you very much.
Operator (participant)
Thank you. Ladies and gentlemen, that is the end of our question-and-answer session. I'd like to turn the floor back to Mr. Larry Dewey for any final remarks.
Larry Dewey (Chairman, President, and CEO)
Well, we appreciate everyone's time this morning. We appreciate the interest and the quality of the questions, and we look forward to talking to you again for the fourth quarter 2015 and 2016, the 2016 outlook call, after the first of the year. Thanks.
Operator (participant)
Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.
