Allison Transmission - Q3 2019

Transcript

Operator (participant)

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's Third Quarter 2019 Earnings Conference call. My name is Melissa, and I will be your conference call operator today. At this time, all parties are in a listen-only mode. After the prepared remarks, the management team from Allison Transmission will conduct a question-and-answer session, and 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 today's call, please press star zero on your telephone keypad. I would now like to turn the conference over to Mr. Ray Posadas, the company's Director of Investor Relations. Please go ahead, sir.

Ray Posadas (Director of Investor Relations)

Thank you, Melissa. Good morning, and thank you for joining us for our third quarter 2019 earnings conference call. With me this morning are Dave Graziosi, our President and Chief Executive Officer, and Fred Bohley, our Senior Vice President, Chief Financial Officer, and Treasurer. 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 November 7. As noted on slide 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 2019 earnings press release and our annual report on Form 10-K for the year ended December 31st, 2018, and uncertainties and other factors, as well as general economic conditions.

If one or more of these risks or uncertainties materialize, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those that we express today. In addition, as noted on slide 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 2019 earnings press release. Today's call is set to end at 8:45 A.M. Eastern Time. In order to maximize participation opportunities on the call, we'll have one question from each analyst. Please turn to slide four of the presentation for the call agenda. During today's call, Dave Graziosi will provide you with an overview of our third quarter results.

Fred Bohley will then review the third quarter financial performance and the 2019 guidance update. Finally, Dave will conclude the prepared remarks prior to commencing the Q and A. Now I'll turn the call over to Dave Graziosi.

Dave Graziosi (President and CEO)

Thank you, Ray. Good morning, and thank you for joining us. We are pleased to report that Allison's third quarter 2019 results are within the full year guidance ranges provided to the market on July 31, and our North America On-Highway end market remains on track for a third consecutive record year, led by ongoing execution of our growth initiatives and market share gains in Class 4, 5 trucks. Furthermore, Allison continues to demonstrate solid operating margins and free cash flow while executing its prudent and well-defined approach to capital structure and allocation. During the third quarter, we settled $46 million of share repurchases, paid a dividend of $0.15 per share, and closed the acquisitions of Walker Die Casting and C&R Tool and Engineering. Earlier this month, we also completed an opportunistic repricing of our $646 million term loan due March 2026.

Please turn to slide five of the presentation for the Q3 2019 performance summary. Net sales decreased 3% to $669 million compared to the same period in 2018, principally driven by lower demand in the Service, Parts, Support Equipment, and Other and Global Off-Highway end markets, partially offset by higher demand in the North America On-Highway end market. Gross margin for the quarter was 52%, a decrease of 120 basis points, as compared to 53.2% for the same period in 2018, principally driven by lower net sales and higher manufacturing expenses, commensurate with increased on-highway volume, partially offset by price increases on certain products and favorable material costs. Net income for the quarter was $149 million, compared to $167 million for the same period in 2018.

The decrease was principally driven by lower gross profit, increased product initiative spending, and increased interest expense, partially offset by lower selling, general, and administrative expenses. Adjusted EBITDA for the quarter was $269 million, or 40.2% of net sales, compared to $295 million, or 42.6% of net sales for the same period in 2018. The decrease in adjusted EBITDA was principally driven by lower gross profit and increased product initiative spending, partially offset by lower 2019 product warranty expense and favorable 2019 product warranty adjustments. Now I'll turn the call over to Fred.

Fred Bohley (SVP, CFO, and Treasurer)

Thank you, Dave. Given Dave's comments, I'll focus on key income statement line items and cash flow. You can also find an overview of our net sales by end market on slide six of the presentation. Please turn to slide seven of the presentation for the Q3 2019 financial performance summary. Selling, general, and administrative expenses decreased $4 million from the same period in 2018, principally driven by lower 2019 product warranty expense and favorable 2019 product warranty adjustments, partially offset by increased commercial activity spending.

Engineering, research and development expense increased $6 million from the same period in 2018, principally driven by increased product initiative spending. Please turn to slide eight of the presentation for the Q3 2019 cash flow performance summary. Net cash provided by operating activities decreased $27 million from the same period in 2018, principally driven by lower gross profit and increased product initiative spending, partially offset by decreased cash income taxes. Adjusted free cash flow decreased $51 million from the same period in 2018, principally driven by lower net cash provided by operating activities and increased capital expenditures. As Dave mentioned earlier, during the third quarter, we settled $46 million of share repurchases and paid a dividend of $0.15 per share.

Earlier this month, we completed an opportunistic repricing of our $646 million term loan due March 29, 2026. The interest rate reduction on our term loan will reduce annual cash interest expense by approximately $1.6 million. This repricing transaction demonstrates Allison's continued commitment to prudent balance sheet management and its well-defined approach to capital structure and allocation. We ended the quarter with a net leverage ratio of 2.12, $152 million of cash, $583 million of available revolving credit facility commitments, and approximately $1.1 billion of authorized share repurchase capacity. Please turn to slide nine of the presentation for the 2019 guidance update.

Our updated full year 2019 guidance includes net sales expected to be in the range of $2.65 billion-$2.7 billion. Net income expected to be in the range of $555 million-$575 million. Adjusted EBITDA is expected to be in the range of $1.035 billion-$1.065 billion. Net cash provided by operating activities is expected to be in the range of $745 million-$775 million. Adjusted free cash flow is expected to be in the range of $570 million-$610 million, and cash income taxes are expected to be in the range of $95 million-$105 million.

Allison's full year 2019 net sales guidance reflects lower demand in the Service, Parts, Support Equipment and Other in North America and Off-Highway end markets, principally driven by lower demand from hydraulic fracturing applications, partially offset by increased demand in North America On-Highway end market, price increases on certain products, and the continued execution of our growth initiatives. Our implied fourth quarter adjusted free cash flow guidance includes capital expenditures for the previously announced expansion of our engineering facilities and testing capabilities, and the payment of interest on $500 million of senior notes due June 20, 2029, that we issued during the first quarter 2019 term loan refinancing. Thank you, and I'll now turn the call back over to Dave.

Dave Graziosi (President and CEO)

Thanks, Fred. In the past, we have emphasized Allison's strategic priorities of global market leadership expansion, emerging markets penetration, product development, and core addressable markets growth while delivering solid financial results and creating value for all stakeholders. Today, we continue to find ourselves with more opportunities to drive innovation and growth than at any other time in our history. These opportunities were illustrated again by the third quarter acquisitions of Walker Die Casting and C&R Tool and Engineering. Walker Die Casting is an industry supplier and a critical source of high tonnage, commercial, and low volume aluminum die castings, a niche area of manufacturing, particularly in North America. Walker has been a supplier and trusted partner to Allison for over 20 years, and their aluminum die-cast components are used in all of Allison's on-highway commercial products.

C&R is a leading supplier of die-cast dies and metalworking tools, primarily for Walker, and complements Walker's ability to grow and support Allison. These acquisitions presented a unique opportunity to leverage Allison's manufacturing and design capabilities through vertical integration with a leading component supplier in the aluminum die casting and machining industry. It enhances Allison's ability to deliver attractive value propositions and secures capacity in a niche area of our supply base. Walker's customers remain important partners, and we plan to continue and grow those relationships. Earlier this week, at the North American Commercial Vehicle Show in Atlanta and in partnership with Freightliner Trucks, Allison announced the launch of the new Allison Regional Haul Series transmission for Class 8 tractor market.

The new Regional Haul Series, an uprated variant of Allison's proven and well-known 3000 Series transmission, has been designed to meet higher engine torque requirements and provide improved efficiency while continuing to deliver the superior reliability, performance, and drivability of an Allison fully automatic transmission. The increased ratings support a growing trend for distribution and regional haul fleets to utilize their trucks in mixed-duty cycles, often in city delivery routes on one shift and regional haul transport routes during a second shift. The Regional Haul Series will provide fleets with 25% faster acceleration and is lighter than the competitive automated manual transmission. In addition, by leveraging Allison's xFE technology as well as Allison's FuelSense 2.0, with DynActive Shifting technology, the Regional Haul Series will deliver a fuel economy improvement of up to 8%.

This product release is the latest example of customer demand driving product innovation. Distribution customers, in particular, have expressed the needs for this product. Allison and Freightliner responded with a drop-in solution for any chassis with a current Allison 3000 Series option. Beginning in 2020, the Regional Haul Series will be available on the Freightliner M2 112 and the Cascadia, both paired with the Detroit DD13 engine and with additional engine pairings to come in the future. This 3000 Series transmission variant demonstrates Allison's consistent ability to leverage existing technology and our brand values to meet or exceed the market's increasing demands for automaticity, fuel economy, and reduced emissions. In closing, these developments are recent examples of the power of Allison.

Though future initiatives will not be linear, we continue to demonstrate that we will take action where appropriate to invest prudently in our business, drive innovation to fuel growth, and secure and enhance our ability to deliver value propositions to our customers. Furthermore, our commitment to prudent balance sheet management as well as capital structure and allocation is key in facilitating Allison's ability to remain resolute and opportunistic in the execution of our strategic priorities. 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'd 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'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 star key. To allow for as many questions as possible, we ask that you each keep to one question. Our first question comes from the line of Rob Wertheimer with Melius Research. Please proceed with your question.

Rob Wertheimer (Founding Partner and Machinery and New Mobility Research Analyst)

Hey, good morning, and obviously, good results. Just a quick question on Service and Parts. Obviously, slowdown in the oil field is no surprise at this point in the quarter. Could you-

Dave Graziosi (President and CEO)

Melissa?

Rob Wertheimer (Founding Partner and Machinery and New Mobility Research Analyst)

This is Rob. Can you hear me?

Dave Graziosi (President and CEO)

We can hear you now.

Operator (participant)

Mr. Wertheimer, your line is live.

Rob Wertheimer (Founding Partner and Machinery and New Mobility Research Analyst)

I'm sorry, it's Rob. Are you guys still there?

Dave Graziosi (President and CEO)

Yes.

Operator (participant)

Yes.

Rob Wertheimer (Founding Partner and Machinery and New Mobility Research Analyst)

I'm so sorry about that. I don't know what happened. The call kind of dropped. Anyway, just trying to figure out on the Service and Parts, whether it was entirely oil field, whether there's anything else, and whether that's bottomed out. Thanks.

Dave Graziosi (President and CEO)

Rob, it's Dave. Good morning. The quick answer to your question is the vast majority of it is North America, frac.

Rob Wertheimer (Founding Partner and Machinery and New Mobility Research Analyst)

Yep. Perfect. And then do you have a sense on it's been volatile, is that, are all the rebuilds out and you're still doing regular parts and service? Is there any more downside there, or have you maybe potentially hit a low point?

Dave Graziosi (President and CEO)

I would tell you the implied fourth quarter guide essentially has Q4 relatively flat with Q3. So, we have continued to work with our customers and end users in terms of their constrained budgets, frankly, for Q4. We've also done a fair amount of work in terms of channel checks and inventory levels. So, we bake that into our assumptions, as I said, which is relatively flat Q4 with Q3. But, in terms of the new unit side of things, you know, obviously very limited, as you've heard over the last few weeks from the public comments that have been made by a number of service providers and then end users in terms of constraints.

Rob Wertheimer (Founding Partner and Machinery and New Mobility Research Analyst)

Perfect. Okay, thanks very much.

Operator (participant)

Thank you. Our next question comes from the line of Seth Weber with RBC Capital Markets. Please proceed with your question.

Speaker 12

Hi, good morning. This is Brendan on for Seth. To start off, I was wondering if you could talk to, I guess, how you're feeling about inventory levels in the straight truck market currently.

Dave Graziosi (President and CEO)

Sure. I assume you're referring to North America, Class 8 straight. You know, we've, we've spent a fair bit of time, as we always do, with end users as well as OEMs. Given the public comments by a number of those parties over the last few weeks, as well as third-party forecasts that are available, I think it's a pretty clear conclusion that inventories are heavy. When I say that, it's inventory retail sales ratio. We've talked about that a number of times this year. As the market comes up, when it comes off a bit and moderates, the inventories tend to need to catch up.

I would tell you, I believe that process is already underway by a number of OEMs as well as end users, managing fourth quarter production rates as well as manning. I'm sure you're aware of a number of public statements that have been made in that regard, but it's pretty clear to us the inventories look high. If you asked us to quantify Class 8 straight truck, in particular, in terms of inventory, it would imply to us, you know, the better part of a month heavy, overall, and I think frankly, that's reflected in the third-party forecasts that are out there for 2020.

Speaker 12

Okay, thank you. And then related to the weakness in fracking, do you think that that's just an issue of the industry needing to sort of lower inventory levels? Or do you think there's an underlying issue that would kind of preclude it from getting better next year?

Dave Graziosi (President and CEO)

Brendan, I think it's, it's a number of things. The, the industry, as you saw, significant reductions, as we understand it, Q3 versus Q2 on the amount of equipment that was stacked in Q3 alone versus even the first half. I would say the, the end users, the service providers are taking very aggressive steps to, to right size the amount of equipment that they have fielded. As I think, you know, we mentioned on the, the Q2 call, the condition of that equipment going into this particular soft point in the market is better, we believe, than the last cycle, the amount of capital that was spent.

That will allow, we believe, the service providers and end users ultimately to carry forward for a bit of time here without doing much in terms of new rig construction. You could call it cannibalization of some of that stacked equipment, but that's our expectation because as we understand it, capital constraints or discipline, depending on the word you like to use, is still prevalent right now in that industry. They're under a tremendous amount of pressure to constrain spending. So that really sets up, you know, as we've implied for the fourth quarter and certainly going into 2020, very muted expectations around new units going into the market. I think the balance of it's really gonna come down to overall utilization rates.

When I say that, in terms of how much of that stacked equipment will ultimately be available to be fielded versus cannibalized. It's very clear, the amount or the level of usage intensity is not going down. The industry continues to push efficiency, which is really driving the consumption of equipment. So there's a number of factors that will ultimately, I think, change some of the dynamics we've seen in prior cycles. But this also sets up for ultimately a recovery into that space. It really becomes a question of when, not if.

Operator (participant)

Thank you. Our next question comes from the line of Ian Zaffino with Oppenheimer & Company. Please proceed with your question.

Ian Zaffino (Managing Director)

Hi. Great, thank you. Can you just square the increase in inventory for the North American On-Highway with basically, you know, your sense that you're going to see increased demand? And how should we be thinking about maybe like the inventory work down, and how it would then, you know, relate to your shipments? Thanks.

Dave Graziosi (President and CEO)

Morning, Ian, it's Dave. A couple of things. In terms of inventory, to the question earlier on Class 8 straight, you know, we talked to that. I would certainly cover the same question for 6, 7 truck. It as well looks heavy to us. I'd probably put that in the range of a month heavy. I think, again, that's been also reflected in third-party forecast. We've assumed a number of different potential outcomes for Q4, and then, of course, positioning for 2020. We're assuming OEMs and other parties in the space are starting to make corrections, as I mentioned earlier, that's already started. That being said, you know, we're, we, as our guide implies, are not expecting, you know, I would say, a higher market on a year-over-year basis in terms of Q4.

It's a tough comp to begin with. When you combine that with some of the strikes that have taken place here recently, that's also created some displacement. It's not a light switch to turn things back on. So we've also included that in our guidance. So I think that sets up for inventory correction going into next year. We'll see how the overall industry positions itself with the shutdown schedules late this quarter.

Ian Zaffino (Managing Director)

All right, great. Thank you very much.

Operator (participant)

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

Jamie Cook (Managing Director of Equity Research)

Hi, good morning. A nice quarter, given the macro out there. I guess, you know, Fred or Dave, just a question, understanding, you know, the sales forecasts are coming down for the fourth quarter, but I guess the margins came down more or the implied margins or EBITDA are down more considerably, even taking into account the fourth quarter, which is seasonally weaker. So can you just help us understand the puts and takes? Because I'm trying to understand the implications for 2020. I assume some of this is you adjusting as your customers are starting to cut production. So maybe fourth quarter EBITDA margins are worse than what you would view as normal.

And then I guess my second question, Dave, you guys have had some success, in 2019, sort of outgrowing the markets and improving your market share. Can you talk about the sustainability of that going into 2020, and how that could potentially offset, you know, a broader industry downturn? Thank you.

Fred Bohley (SVP, CFO, and Treasurer)

Hi, Jamie, this is Fred. I'll take the first portion of that question. You know, our implied fourth quarter guidance, as Dave mentioned, takes into account a variety of potential outcomes, most notably the negative impacts of volume and mix. You know, primarily driven by reduced demand from North American Off-Highway new units and service parts, the elevated North American On-Highway inventory levels and the Q4 impacts of the OEM work stoppages. It also includes increased R and D and SG&A expense to support our growth initiatives, product development and capital projects, and includes favorable pricing on certain products....

Dave Graziosi (President and CEO)

Jamie, this is Dave.

On your market share questions, you know, we've fortunate this year to be able to reenter the 4 or 5 space with the GM Silverado and the NAV CV Series. Those products seem to be well received by the market. That certainly helped us recover a position that, as you know, dates back almost a decade at this stage. So we believe that is certainly sustainable, subject to both of those platforms maintaining their position in the market, if not growing. We've also done well this year in terms of Class 8 straight truck, as well as Metro, our so-called Rugged Duty Series, as well as our Highway Series transmissions.

It's clear that, as we've talked before, and then you're well aware of the push for automaticity in the space, and safety and reliability, that certainly plays well with our brand value, values, as well as the execution of the overall service model for end users. So, we believe that as well is a great position for the team. They've worked very hard on that and continue to try to grow that position with a number of different programs. I would also tell you, the announcement earlier this week that I mentioned at the North America CV Show, for a lot of reasons, that continues to give us the opportunity to expand share as well in terms of Class 8 Metro. You know, that space is moving very quickly to further automaticity.

We believe it's a great value proposition, and again, that was really market driven. You know, we've talked before about our product lineup and what we're spending on. It really needs to be market demand driven, so we're happy with that outcome. Outside North America, continuing to take our value proposition into really core applications. That being said, you know, the push for electrification, specifically in bus in China, has created some headwind for us overall. We've directed or redirected some of our resources onto into the truck space more specifically. We feel good about our positioning there as well, again, from a performance of the product perspective. So overall, that combined with other releases we've secured as well in some of the emerging markets, continue to perform well.

Those are, you know, effectively penetration gains as well.

Operator (participant)

Thank you. Our next question comes from the line of Larry De Maria with William Blair. Please proceed with your question.

Larry De Maria (Group Head of Global Industrial Infrastructure)

Thanks. Good morning, everybody. Obviously, we're hearing a lot about, not just from you guys, but from other companies about, softer order books and reflected in guidance. But just curious, what's kind of the magnitude of the last, say, 60 days, how orders have trended downward, and have they stabilized? And is there a way to maybe ballpark the impact of the strike? Did that hit 3Q and then slowly come back in 4Q?

Dave Graziosi (President and CEO)

Good morning, Larry, it's Dave. A couple things. We, from a strike perspective, we don't get in front of our customers. We'll let them quantify what those impacts are. You know, we certainly felt some of it in Q3, but as you know, the math is, the majority of it is Q4 schedule. We'll also let the OEMs talk to their recovery plans, if any, for the balance of the year relative to those two events. We're certainly happy to get those as they are resolved and behind us, but the fact is, the inventory levels that were discussed earlier create some level of buffer anyway.

So from my, from our perspective, it just becomes a question of timing, whether you get through some of that inventory reduction sooner rather than later, relative to recovery periods more broadly in the market. That certainly sets up a position. Again, I think that has been reflected in third-party forecasts already for 2020. Of course, deciphering those into what's relevant for Allison's end markets, specifically as we talk about 6, 7 truck, as well as Class 8 straight, et cetera, you know, we'll deal with our specific thoughts on 2020 as we normally have in the first quarter with the fourth quarter call, and provide that particular level of guidance. But it's to Fred's earlier comments, we've assumed a number of things.

Obviously, in our fourth quarter guidance, there's a number of different outcomes there. But you can imagine, as we've just rattled off a number of them here this morning, it's a relatively active quarter, probably one of the more active quarters we've had in several years, with a number of these, both micro as well as macro events, really impacting the business.

Larry De Maria (Group Head of Global Industrial Infrastructure)

Okay, thanks. Just real quick, I think CapEx was increased. Sorry if I missed it, but was there a reason for the increase in CapEx?

Dave Graziosi (President and CEO)

As you know, yes, there is. We have a number of projects that we're investing in terms of our engineering capabilities. One is a Vehicle Environmental Test Facility. We had a number of discussions and meetings around that at the North American CV Show here this week. That will allow us to do expand our both our internal capabilities as well as the ability to serve third parties in that facility. So that spending is well underway and that facility will be completed in 2020 and available for our expectation is for third-party use second half of next year. The other big project we have for product engineering is an Innovation Center. That is planned to be completed in 2021.

So, that's incorporated into the spending for our guide, which is you can do the math, the implication, as Fred mentioned in his comments around heavier amount of CapEx really being in the fourth quarter. That's really schedule driven in terms of timing and materials, as well as the ability of third parties to execute those projects on our behalf.

Operator (participant)

Thank you. Our next question comes from the line of Tim Thein with Citigroup. Please proceed with your question.

Tim Thein (Analyst)

Thank you. Good morning. Dave, maybe just continuing on that thought process there, from the standpoint of free cash flow, and we're not talking about 2020, but as we think about just the key levers, obviously, or I would assume that CapEx normalizes in 2020. You know, historically, there tends to be in an environment where the top line is softening some counter cyclical working capital movement.

So I'm just again, high level, is it conceivable, to the extent you do have a softer EBITDA year in 2020, that you would have items that would enable the company to at least, you know, hold free cash flow at a similar level in 2020? Thank you.

Fred Bohley (SVP, CFO, and Treasurer)

Sure, Tim. This is Fred. On working cap, certainly the, you know, the expectation there, you know, we target 10%-11% of LTM sales. So in a environment where sales is coming down, yes, that should be a source of cash. And I'll let Dave speak to CapEx.

Dave Graziosi (President and CEO)

On the CapEx issue, the projects that I just mentioned in terms of the engineering capability investments, they'll also be spending next year, Tim, so as you start to work those out, the Vehicle Environmental Test Facility spending will be lighter than it is in 2019. The opposite happens with the innovation centers. That spending will actually be up, because the vast majority of the construction will occur next year. To your point, in terms of how we manage the business from a softness or it's, you know, there's more growth and more demand, we manage our business through the cycle. So there are a number of investments that we make, you would call sustainment or maintenance, those will continue to occur. Can we curtail those? Depending on the circumstance, yes.

Having said that, that becomes more of a timing issue. Our plans for 2020 also incorporate a number of other initiatives that we'll address in the first quarter. So I would, I think it would be a mistake to set the expectation necessarily that our capital spending would be significantly lower in 2020 versus 2019, just because of the projects we already have underway. But again, that being said, depending on market conditions, there's a number of things that we can move to defer level of spending as well. And, you know, we'll see what what 2020 develops at, but we, you know, as we've done in other market cycles and situations, make appropriate adjustments.

But again, we take a view of the business through the cycle, and it's important to understand what that means.

Operator (participant)

Thank you. Our next question comes from the line of Ross Gilardi with Bank of America. Please proceed with your question.

Ross Gilardi (Equity Research Analyst)

Yeah, just following up on, you know, Tim's question and some of those thoughts, Dave. I mean, how should we think about decremental margins, if we go into a downturn this cycle relative to prior cycles, maybe given that, you know, you do have growth investment, and, you know, you do have a greater focus on, you know, alternative propulsion, many of these new technologies and so forth. Can you kind of sustain decrementals where in prior cycles are perhaps maybe higher this time around?

Dave Graziosi (President and CEO)

Ross, it obviously depends in terms of your assumptions on the overall mix of the book of business. You know, as we've talked about, I think a reasonably safe expectation, just thinking about North America On-Highway, which is an attractive margin business, that situation is not, you know, at this point, I would say, setting up extremely well for 2020. So when you start to run through, to answer your question on decrementals, it really comes back to the level of volume mix, right? There's a number of other things as we think about the portfolio. Just looking at third-party forecasts for North America On-Highway volume, that also portends to be, you know, a somewhat unfavorable mix.

So, as we're pulling our, our thoughts together for 2020, we'll be providing those, as I said, in the first quarter of next year. But we'll certainly work to do our best to, to minimize the impact of those decrementals, but at the same time execute on the initiatives that are, are necessary to grow the business through the cycle.

Ross Gilardi (Equity Research Analyst)

And then if you have a downturn year, do you think you can continue to sustain, you know, the level of pricing that you generally get through the cycle or on an annual basis, or you generally see a pause, if not a somewhat of a kickback, in year one?

Dave Graziosi (President and CEO)

We, you know, typically, as you know, there's opportunity for pricing as long as we're delivering differentiated value. We believe there is continues to be opportunity there. Do I expect it, to your point, to be the same with a moderating market? Not necessarily, but I do expect that we'll continue to enjoy some level of price.

Ross Gilardi (Equity Research Analyst)

Okay, thanks, Dave.

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 and Head of U.S. Machinery Engineering and Construction Franchise)

Yes, hi, good morning. Can we just continue the discussion that you just had? So in your prepared remarks, you spoke about the strong product cadence and the Regional Haul Series. Can you folks talk about the percent fuel economy improvement that you expect across the product lineup that we're gonna see in 2020? And, you know, as you pointed out, typically that's linked to your pricing as well. So just trying to understand if we're gonna get a stronger product cadence in 2020 compared to what we've seen over the past couple of years, which sounds like might be the case based on the prepared remarks, but I'm wondering if you could flesh that out for us.

Dave Graziosi (President and CEO)

Sure, Jerry, Dave, good morning. I a couple things there. I mentioned the, in the, description of the, the 3414 Regional Haul Series product, that has FuelSense 2.0, as you know. That's a relatively recent addition in terms of our on-highway product lineup. We continue to ramp the adoption rate of that. So, the reason for that, to your point, is that, there is a demand, higher demand for fuel efficiency in the market. We're continuing to drive the adoption of that, so I think you'll see- should expect to see more of that. There's a number of OEM programs that we have to increase and drive that adoption as well, some standard offerings. So, that's something that's in front of us, to your point.

I would also mention that our team continues to work on a number of different variants of our existing products, to really improve the fuel efficiency. Some of that is handled through mechanical changes. Some of it is handled through controls changes and software. It's a combination of those, but it's clear that there is a need in certain portions of the market, not all of them, I would certainly tell you. But a number of subsegments within on-highway are looking for certainly more fuel efficiency. So, beyond the RHS, the FuelSense 2.0, there's a number of other product variants that we're working on, up to and including the nine-speed product that we announced, you know, almost two years ago now, that the team continues to work on.

That being said, as I mentioned earlier, you know, we really wait and see from a market demand perspective, the pull for additional technology. And that's a good example of, you know, where the market ultimately lands, and we're prepared to provide that technology to the extent there is, demand for it.

Jerry Revich (Senior Investment Leader and Head of U.S. Machinery Engineering and Construction Franchise)

Okay. And maybe just a clarification on the guidance. So taking midpoint of sales and EBITDA, just to expand on that, you have EBITDA in the fourth quarter down $80 million or so year-over-year on a $100 million decline in sales. And you know, we haven't seen that type of decremental margins from you folks in the past. So is that just a function of using midpoint for each number late in the year, or are there other factors at play? And I appreciate your prior comments on the strike, but you have price costs, that's a tailwind, and other positive factors. So can you just address that point in a little bit more detail, please?

Fred Bohley (SVP, CFO, and Treasurer)

Sure, Jerry, this is Fred. As we spoke of on our, really, on the Q1 and Q2 earnings call, and we did expect, engineering R and D to be up $20 million year-over-year. That would imply, that, that Q4 2019 be up, approximately $10 million, above Q4 2018. We also expect, SG&A expense to, to be elevated. So those would be the, two items that I'd point to in, in addition to the comments we made around, volume and revenue.

Jerry Revich (Senior Investment Leader and Head of U.S. Machinery Engineering and Construction Franchise)

All right. Thank you.

Operator (participant)

Thank you. Our next question comes from line of Courtney Yakavonis with Morgan Stanley. Please proceed with your question.

Courtney Yakavonis (Equity Analyst)

Hi, thanks. Just to follow up on that, you mentioned that SG&A will be elevated in the fourth quarter. You know, I think at the beginning of the year or earlier, you had mentioned that SG&A would be, you know, close to flat for the year. So obviously, that does imply a big step up in the fourth quarter. Is that still what we should be using? And I think, you know, most of the beats on SG&A over the past three quarters have really been attributed to favorable warranty costs relative to last year. So just when we think about, you know, SG&A levels for next year, is this year a normalized warranty level, or is it below, or was last year high and this year's normal? Thanks.

Fred Bohley (SVP, CFO, and Treasurer)

Sure, Courtney, this is Fred. The expectation at this point, based on the favorability we've seen in policy and warranty, is for SG&A to be down year-over-year, however, still up in Q4 over prior year. Specific to you know, beyond 2019, you know, the favorable adjustments we've had from a product warranty standpoint, you know, would not be expected to continue. You know, that's a quarterly process that you know, we true up those accruals.

Certainly, product's been performing well, but that's not something that, you know, we would anticipate, rolling into 2020.

Courtney Yakavonis (Equity Analyst)

Okay, thanks. And then, you know, I think you referenced this a little bit earlier, but, you know, with the implied step down in sales in the fourth quarter that's in your guidance, can you just talk a little bit? You know, I think you had originally given some end market guidance at the beginning of the year, and we haven't necessarily gotten an update. But, you know, for something like North America On-Highway, which is obviously performed much stronger than expected for the first three quarters of the year, how much of the implied guide down was really because of shift there versus a shift in some of your other end markets? Thanks.

Fred Bohley (SVP, CFO, and Treasurer)

Sure, Courtney. I mean, one thing I guess I'd point out, we, you know, we reaffirm guide, narrowed the ranges. You know, but as you, as you think about, you know, full year, certainly we're coming in quite a bit stronger in North America On-Highway. You know, I think our initial, full year guide was, up 5%. We're closer to up 10%. But, you know, we're relatively close to the, you know, initial guide, where we had a pretty pessimistic view of, North America Off-Highway and, the associated parts. Unfortunately, those have come to fruition.

Above and beyond that, I'd say things are relatively consistent, you know, with the guide that we provided back in February and really with the Q2 guide as well, where we've, you know, in effect, narrowed the ranges and reaffirmed guidance.

Operator (participant)

Thank you. Ladies and gentlemen, that concludes our question and answer session. I'll turn the floor back to Mr. Graziosi for any final comments.

Dave Graziosi (President and CEO)

Thank you, Melissa. As we've said before, it's an exciting time to be part of Allison. We find ourselves today with more opportunities to drive innovation and growth than in any other time in our history, and we look forward to providing you with further updates in the months to come. Thank you for your continued interest in Allison and for participating on today's call. Enjoy the rest of your day.

Operator (participant)

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.