Allison Transmission - Q3 2023

Transcript

Operator (participant)

Good afternoon. Thank you for standing by. Welcome to Allison Transmission third quarter 2023 earnings conference call. My name is Alicia, and I'll be your conference call operator today. At this time, participants are in a listen-only mode. After prepared remarks, Allison Transmission's executives will conduct a question-and-answer session, and conference call participants will be given instructions at that time. As a reminder, this conference call is being recorded. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. I would now like to turn the conference call over to Jackie Bolles, Executive Director of Treasury and Investor Relations. Please go ahead, Jackie.

Jackie Bolles (Executive Director of Treasury and Investor Relations)

Thank you, Alicia. Good afternoon, and thank you for joining us for our third quarter 2023 earnings conference call. With me this afternoon are Dave Graziosi, our Chairman and Chief Executive Officer, and Fred Bohley, our Senior Vice President, Chief Financial Officer, and Treasurer. As a reminder, this conference call, webcast, and this afternoon's presentation are available on the Investor Relations section of allisontransmission.com. A replay of this call will be available through November 8. 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 2023 earnings press release, our annual report on Form 10-K for the year ended December 31, 2022, and other general economic factors.

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 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 2023 earnings press release. Today's call is set to end at 5:45 P.M. Eastern Time. In order to maximize participation opportunities on the call, we'll take just one question from each analyst. Please turn to slide four of the presentation for the call agenda.

During today's call, Dave Graziosi will review highlights from our third quarter 2023 results and provide an update on recent announcements across our product portfolio. Fred Bohley will then review our third quarter financial performance and the full year 2023 guidance. Dave will close with a review of our wide-body mining dump and defense end market growth opportunities prior to commencing the Q&A. Now, I'll turn the call over to Dave Graziosi.

Dave Graziosi (Chairman and CEO)

Thank you, Jackie. Good afternoon, and thank you for joining us. During the third quarter, net sales increased 4% year over year to $736 million. Sales gained momentum throughout the quarter after a slow start, driven by supply chain constraints and expanded OEM shutdowns in July, resulting in August and September sales volumes above monthly levels in the first half of the year. Net sales growth was outperformed by growth in net income, up 14% and diluted EPS, up 21% to $1.76. Furthermore, our team's efforts towards price realization and cost mitigation drove gross margin expansion of 230 basis points year over year. Our capital investments continue to fund the ongoing expansion of our technology capabilities, as well as product development focused on value propositions that address the challenges of our evolving end markets.

These next-generation initiatives, along with the various financial, operational, and strategic milestones that we have achieved over the last several years, demonstrate the power of Allison to capitalize on market opportunities with new products, to drive innovation and growth, and create value for all of our stakeholders. The next-generation initiatives also underscore our dedication to remaining a leader in propulsion solutions across all of the end markets we serve and are instrumental to driving future growth. Allison is committed to offering a portfolio of conventional, electric, hybrid, and fully electric propulsion solutions designed to meet the needs of customers. Today, I would like to highlight recent announcements across our On-Highway product portfolio, starting with alternative fuel sources for our conventional products. In the quarter, we announced our currently exclusive release with Mack Trucks for their compressed natural gas-powered Granite model truck.

To meet the need of refuse collection customers, Allison's proven 4000 Series transmission was seamlessly paired with a CNG engine. This partnership is the latest example of Allison's ability to deliver optimized performance and capability in demanding vocations, indifferent to the fuel source for the powertrain. Moving forward with Allison's transit hybrid offering, our eGen Flex system, adding to the many nationwide releases we have highlighted in recent quarters, we are pleased to announce earlier this month that the B-Metro, the public transit system in Brownsville, Texas, has chosen to equip their buses with the Allison eGen Flex system. Brownsville joins the growing list of transit properties in states such as Indiana, Wisconsin, Nevada, and California that will utilize the eGen Flex electric-only capabilities, activated by Geofencing technology to automatically switch to engine-off mode in densely populated areas of the city.

We are excited for this partnership and remain committed to collaborating with transit agencies nationwide to support them in their emissions reduction goals. Wrapping up with our eGen Power of fully electric e-Axles, we were excited to launch the eGen Power 85S, the newest addition to the eGen Power family. Partnering with Anadolu Isuzu, the 85S was integrated into a fully electric 8 m minibus and released at Busworld Europe in early October. The eGen Power 85S was specifically developed to address the needs of minibus and small truck applications, and joins the larger 100S and 130S in the single motor eGen Power e-Axle family. The introduction of the 85S is the latest example of Allison's commitment to expanding our propulsion solution portfolio to meet the demands of the wide variety, range of applications and market segments we serve.

In summary, Allison's third quarter results demonstrate strong operating performance, with the business well-positioned across our fuel source in different product portfolio. Our products have been developed to support our customers' needs as they adapt to different technology sources and driving future growth across our business. Thank you, and I'll now turn the call over to Fred.

Fred Bohley (SVP, CFO, and Treasurer)

Thank you, Dave. Following Dave's third quarter 2023 comments, I'll discuss the Q3 2023 performance summary and the Q3 2023 cash flow performance. I'll then reaffirm the full year 2023 guidance. Please turn to slide five of the presentation for the Q3 2023 performance summary. Third quarter net sales increased 4% from the same period in 2022 to $736 million. The increase in year-over-year results was led by a $36 million increase in net sales from the North American On-Highway end market, principally driven by strength in customer demand for Class 8 vocational and medium-duty trucks and price increases on certain products, and a $14 million increase in the service parts, support equipment, and other end market, principally driven by strength in North American On-Highway service parts and support equipment, and price increases on certain products.

Year-over-year results were also improved by an $8 million increase in the net sales from the defense end market, principally driven by increased demand for tracked and wheeled vehicle applications. Gross profit for the quarter was $357 million, an increase of $29 million from $328 million for the same period in 2022. The increase was principally driven by price increases on certain products, partially offset by higher manufacturing expense. Net income for the quarter was $158 million, compared to $139 million from the same period in 2022. The increase was principally driven by higher gross profit, partially offset by increased selling, general, and administrative expense. Adjusted EBITDA for the quarter was $267 million, compared to $245 million for the same period in 2022.

The increase was principally driven by higher gross profit, partially offset by increased selling, general, and administrative expenses. Diluted earnings per share increased 21% from the same period in 2022. Third quarter diluted EPS of $1.76 was driven by higher net income and a lower total shares outstanding. A detailed overview of our net sales by end market and Q3 2023 financial performance can be found on slides six and seven of the presentation. Please turn to slide eight of the presentation for the Q3 2023 cash flow performance summary. Adjusted free cash flow for the quarter was $182 million, flat from the same period in 2022, driven by increased net cash provided by operating activities, offset by increased capital expenditures. During the third quarter, we returned capital to shareholders through a quarterly dividend of $0.23 per share.

We also repurchased $20 million of our common stock, with nearly 4% of our shares outstanding, repurchased in the first three quarters of 2023. Since our IPO in 2012, we have repurchased over 60% of our outstanding shares. We ended the quarter with a net leverage ratio of 1.9x, $501 million of cash, and $645 million of available revolving credit facility commitments. In addition, we continue to maintain a flexible, long-dated and covenant-light debt structure, with the earliest maturities due in 2026. Of our $2.5 billion of outstanding debt, $620 million is subject to variable interest rates, of which $500 million is hedged, resulting in 95% of our debt being fixed through the third quarter of 2025.

Please turn to slide nine of the presentation to review our 2023 guidance. Given third quarter results and current end market conditions, we are reaffirming our full year 2023 guidance provided to the market on July 27, 2023. Allison expects net sales to be in the range of $2.96 billion-$3.04 billion. At the midpoint, this represents over 8% year-over-year growth based on the continued strength and demand in the majority of our end markets, price increases on certain products, and the continued execution of our growth initiatives, leading to another anticipated record net sales year.

In addition to Allison's 2023 net sales guidance, we anticipate net income in the range of $575 million-$625 million, Adjusted EBITDA in the range of $1.05 billion-$1.11 billion, net cash provided by operating activity in the range of $675 million-$725 million, and capital expenditures in the range of $125 million-$135 million, and adjusted free cash flow in the range of $550 million-$590 million. Thank you, and I'll now turn the call over to Dave for an update on our wide-body mining dump and defense end market opportunities.

Dave Graziosi (Chairman and CEO)

Thank you, Fred. During the quarter, we announced that several Chinese mining equipment manufacturers have expanded their exports of wide-body mining dump trucks equipped with Allison transmissions to the Americas, Asia, and the Middle East. Increasing export opportunities for wide-body mining dump trucks was one factor that led to our resizing of the opportunity to $100 million of annual incremental revenue during the first quarter. Our long-standing partnerships with major mining OEMs in China continue to lead to further global penetration in this vocation. Allison is growing our international defense business through partnerships with global defense OEMs, such as Hanwha Aerospace, with utilization of Allison products not only in South Korea but in various tracked and wheeled applications for customers around the world. Last week, we announced that our Allison X1100 cross-drive transmission was selected as the propulsion solution for the Hanwha Redback armored vehicle.

The Redback is Hanwha's newest tracked vehicle, chosen to be Australia's infantry fighting vehicle of the future and selected for Australia's LAND 400 Phase 3 program. The Redback strives to duplicate the success of Hanwha's K9 self-propelled howitzer family of vehicles, which has been chosen for numerous European, Asian, and North African programs utilizing the Allison X1100. During the quarter, Allison was awarded the $13 million second-phase, low-rate initial production contract for the U.S. Army's M10 Booker light tank program, formerly the MPF. We look forward to ramping into higher production volumes with the M10 Booker, utilizing Allison's new 3040 MX medium weight cross-drive transmission. Development of new products, such as the 3040 MX, will drive international growth in the near future as the demand for medium-weight armored combat vehicles increases with shifts in geopolitical dynamics.

Also, during the quarter, Allison signed a memorandum of understanding with PGZ, a Polish defense holding group and one of the largest defense companies in Europe. The MOU includes cooperation on tracked vehicle programs, as well as partnership to provide service and repair in Poland, adding to Allison's network of authorized dealers and distributors. Poland has contracted to purchase several hundred Abrams tanks, as well as hundreds of Hanwha's K9 howitzers using Allison products. The PGZ has also recently been awarded a contract for over 1,000 Borsuk infantry fighting vehicles. This partnership will further Allison's relationships with global defense industry participants and advance the realization of our $100 million incremental annual revenue opportunity. This concludes our prepared remarks. Alicia, please open the call for questions.

Operator (participant)

Thank you. We will now 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 keys. One moment, please, while we pull for questions. Thank you. Our first question comes from the line of Larry De Maria with William Blair. Please proceed with your question.

Larry De Maria (Capital Goods Analyst)

Thanks. Good afternoon, everybody, and thanks for all the color on the mining stuff. Question, you know, you had very strong operating performance in the quarter, especially the margins. The sales were a little below, but you noted you had a slow start on supply chain. So, you know, to clarify that, did you catch up throughout the quarter, or is there some more wood to chop that goes into the fourth quarter? And the second part is, can you describe the UAW situation, both upstream, downstream, and how that's, you know, implied in the guidance for the rest of the year, whether that becomes an issue or not? Thank you.

Dave Graziosi (Chairman and CEO)

Larry, it's Dave. Good afternoon, and appreciate the questions. On your first question, in terms of the activity that we saw in the third quarter, the slow start really referred to component constraints at the OEM levels. So as we entered our expectation was more of a normal run rate, frankly, for July. That proved to be a bit disconnected from what the OEMs were experiencing. I would refer you to the OEMs that have publicly reported already in terms of some of their commentary around the constraints that unfortunately they were dealing with, and we reacted accordingly. As we noted in the prepared remarks, certainly August and September run rated at a higher level or more consistent with what we saw in the second quarter.

So, in terms of carryover into the fourth quarter, obviously, as our midpoint implies, which is a lack of change in the midpoint, we see a number of activities happening in the fourth quarter. Some of that will be some level of carryover, at least expectation that constraints will be mitigated a bit. So and I think, again, referring you back to the public comments of OEMs, I think that's consistent with some of the comments that they've made as well. So, in terms of your question on the UAW negotiations, you know, Allison is certainly committed to providing competitive wages and benefits to all our employees, which includes those represented by the United Auto Workers. A team of Allison management and UAW Local 933 leaders have begun discussions at an off-site location.

You know, the company is focused on negotiating an agreement that creates flexibility, simplicity, and efficiency. This focus allows us to continue to provide the highest quality product to all of our current and future customers. You know, in terms of the activities that are going on with the automakers, you know, I would just offer that, and I'm sure you know, at Allison, our UAW-represented employees have a labor contract that is unique to our organization and negotiated separately from the contracts of the Big Three, so to speak. So, as such, the UAW strike affecting the Big Three does not have any direct impact on our local operations.

Larry De Maria (Capital Goods Analyst)

Very much.

Operator (participant)

Thank you. Our next question comes from the line of Rob Wertheimer with Melius Research. I apologize.

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

Not, not a bit. Hi, thank you. So I know it's not your biggest business, but the reasonably sharp decline in Off-Highway, both domestically and international, was a bit of a surprise. Your slides called out, I, I guess, energy, and I'm, I'm just curious what happened there. I don't quite know your mix within those segments, if it's just energy or if there's anything, construction or mining, that, that materially changed. And I don't know if that's a synchronous or a coincidental decline, because I, I assume the international is more China gas fracking. Anyway, could you maybe just elucidate what happened there?

Dave Graziosi (Chairman and CEO)

Rob, it's Dave. So, a few things, just a little context. The Off-Highway business, by you know definition, is probably one of our more volatile end markets, and history has certainly proven that. You know, as we entered this year, our expectation was certainly more of a stable setting in terms of players, especially within the North American energy market. I think, as you know, there's been a number of transactions that have been announced. That was certainly not part of our plan coming into the year. That has naturally led to a reconsideration of those impacted players, and I would say the broader industry around fleet sizing, capital deployment, as well as replenishment. So, we're seeing some of that, frankly, play its way through the market.

North America, I think, as you well know, is largely an energy market for us. So, the other thing that continues is the high level of capital discipline within that particular end market, and the increased cost to cap has certainly proven that out as the players continue to focus on cash flow and return on their operations, and frankly, margins. So, we would expect that situation to play out, near to medium term. Our sense is, you know, the fleets are pretty well equipped at this point. They've done a number of refurb projects.

Some of that has then led into some new unit sales, but, you know, our sense is that there's adequate amount of equipment when you look at supply-demand balance, and I think service companies will naturally try to maintain that balance. Outside North America, that portfolio is more evenly split between energy and mining, construction, hauling, if you will. So that portfolio continues to evolve well. You know, in our prepared remarks, referring to the wide-body mining dump, I would say to my comment, in terms of one of our more volatile end markets, some of that activity is really tied to tenders that are being executed by the vehicle OEMs.

So to the extent that they're occurring on time or the buyers are actually executing the tenders, that really drives the—obviously, the volume through our side. You know, our experience, at least entering, you know, the fourth quarter and a portion of the third quarter, was some of those tenders getting pushed a bit. So we'll be revisiting all of that, as you would expect, as part of our 2024 guidance in the first quarter. But it's something we're obviously staying close to, from a volume and timing expectation.

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

Perfect. And if I can just ask one that matters more, I guess. vocational and medium-duty outlook, or, or customer orders, or your impression of the current state of the market there. I don't suppose it's experiencing the kind of weakness you might see in the you know, On-Highway, you know, freight heavy-haul side, but just to make sure that that still looks on track. I'll stop.

Dave Graziosi (Chairman and CEO)

We wouldn't disagree with your assessment there. I think it's, you know, we're fortunate with, you know, our portfolio, as you well know, being weighted in medium-duty as well as vocational and municipal as well, but those markets continue to hold up well. Again, the public comments by the OEMs, you know, the references back to some continued gaps in what fleets are looking for from a replacement perspective, and I think the industry is still trying to catch up a bit. The average age of vehicles continues to increase, so, you know, we're following that trend. We, you know, as you mentioned, continue to see a pretty firm market for medium-duty as well as Class 8 vocational, and I think as the, again, public comments by the OEMs are consistent in that view.

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

Thank you.

Operator (participant)

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

Tim Thein (Analyst)

Thanks. Yeah, good evening. The question, Dave, is, or Fred, just on pricing. I think the expectation for the year was maybe just under 500 basis points of price capture for this year. Is that still the expectation? And then, you know, just to continue on your last thread, in terms of what the OEMs seem to be signaling in terms of relative strength in the On-Highway markets most important to you, especially the vocational segment, and I think some have communicated at least their attempts, initial attempts for price increases in 2024. How do you think Allison fares in that kind of backdrop, should that hold? Thank you.

Fred Bohley (SVP, CFO, and Treasurer)

Yeah, Tim, this is Fred. You know, from a pricing standpoint, it was another strong quarter from a pricing standpoint. You know, as you know, we passed on pricing throughout 2022, so the comps become difficult as you progress through the year. But, you know, over $30 million in price, close to 470 basis points in the quarter. You know, revenue really up about 400 basis points. So you're really looking at price driving the revenue performance. I'd say what's encouraging about that is on fairly constant volume, you know, our gross margins are up 230 basis points, you know, EBITDA margins up 180 basis points.

So we're in a situation where we clearly have price outrunning cost, and you're seeing those really drop through, from a margin standpoint. You know, for, for the full year, you know, we're still tracking to that, you know, that total 500 basis points, you know, roughly $150 million in price realization on a year-over-year basis. And, you know, relative to 2024, you know, as we've talked about on numerous calls, you know, as the vehicles continue to increase in price, you know, our value prop is that we make those vehicles, you know, run more efficiently. Less repair time, more vehicle uptime. Ultimately, you can, you know, get from point A to point B quicker. You can size fewer vehicles in your fleet.

So as the, you know, the vehicles continue to advance, whether it's, you know, inflation cost pressures driving that, or, you know, outside North America, moving up the emissions curve and adding safety features, it just, you know, significantly increases our value proposition. And, you know, we've been in a position to both take advantage of that from a price and a share standpoint. So we're certainly gonna continue to monitor, you know, what the, the OEM price actions will look like going into 2024, but we do anticipate, you know, another, you know, think historically pre-pandemic, 50-100 basis points of price. We do anticipate in 2024, you know, pricing significantly above, those historical pre-pandemic levels.

Tim Thein (Analyst)

Thank you, Fred.

Operator (participant)

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

Isaac Sellhausen (Equity Research Associate)

Hey, good afternoon. This is Isaac Sellhausen on for Ian. Just to follow up on Off-Highway, you know, does the reaffirm guidance assume we see Off-Highway recover in fourth quarter? You know, or will On-Highway perhaps make up for some of the lower performance there, given the, you know, the dynamics you discussed in Off-Highway?

Fred Bohley (SVP, CFO, and Treasurer)

Yeah, I think, you know, as Dave commented, you know, on, on Off-Highway, you know, our expectation with, outside North America is, there's been an element of timing. And, you know, we do have, you know, an elevated expectation for, you know, for Q4 and outside North America, Off-Highway, versus what we saw in Q3. Relative to North America, that's something we're gonna continue to, to closely monitor. You know, North America, you know, On-Highway, I mean, Dave hit on it. I mean, there's a significant amount of demand for medium-duty and Class 8 straight. And, you know, we feel very solid about where that, that order book is, going into the fourth quarter.

Isaac Sellhausen (Equity Research Associate)

Great. Thanks very much.

Operator (participant)

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

Tami Zakaria (Executive Director)

Hi, thank you so much. My question is on the impressive gross margin expansion, 230 Basis Points. I think this is the highest we've seen this year. How should we think about it for the fourth quarter? And also, how should we think about Gross Margin in general as you start lapping these expansions next year?

Fred Bohley (SVP, CFO, and Treasurer)

Hi, Tami, this is Fred. You know, obviously, I think, you know, with us providing, you know, full full-year guide, you know, you can, you can back into the midpoint guide for fourth quarter. You know, we, historically, you know, fourth quarter's been our lowest margin quarter. You know, obviously a lot of that is dependent on top-line revenue, but, you know, North America, you've got the, you know, the holidays, you know, November and December, which, traditionally you have a little bit more fixed costs, which puts a little pressure on, you know, on margins in the quarter. You know, as things, you know, play forward, you know, there's, there's a lot of moving pieces. You know, we've seen, you know, commodity prices come off.

You know, that's been advantageous to us, but, you know, we continue to see labor pressure, you know, through our supply chain. You know, that's driving, you know, increases to our value add. You know, as we talked about, you know, still the challenges in the supply chain and some inefficiencies that are out there for us to get after. Expedited freight, some manufacturing efficiencies within our facilities, you know, carrying a little bit more inventory than you'd like. And then obviously, you know, I commented early on, where we are from a price expectation. So, you know, we continue to, you know, to form our view, you know, on 2024, and, you know, all those, you know, puts and takes will be taken into consideration, when we provide that initial guide in February.

Tami Zakaria (Executive Director)

Great. Thank you.

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, Infrastructure, and Sustainable Tech Franchise)

Yes, hi, good afternoon. Fred, I'm wondering if you could just talk about capital deployment from here. Obviously, a strong track record of returning cash to shareholders. You know, you ended the quarter, I think, with your highest quarterly balance as a public company. So I'm just wondering how you folks are thinking about capital deployment from here, and why we didn't see more significant stock buyback in the quarter given the cash generation? Thanks.

Fred Bohley (SVP, CFO, and Treasurer)

Sure, Jerry. I mean, you know, our capital allocation priorities are, you know, have been consistent. You know, I mean, we're gonna, you know, fund the business, you know, for organic revenue and earnings growth, you know, focus on new product technology development. And you really see that in, you know, the capital expenditures we've had, the engineering R&D, the fact that we kept our foot down on those investments throughout the pandemic. You know, what's out there from, you know, strategic acquisitions. But we've returned, you know, a significant amount of capital to shareholders. You know, I mean, we've, you know, repurchased over 60% of our shares. You know, we've raised the dividend, you know, over the last five years, you know, on a, you know, dividend payout per share by over 50%.

You know, obviously, a big driver for us is to, you know, always have, you know, you know, to be managing the balance sheet and have, you know, low cost, flexible, prepayable debt structure, you know, long dated maturities. So, you know, as we sit here, the priorities, you know, they haven't changed. You know, we're at this point, obviously, as you mentioned, carrying a little higher cash balance than we have historically. You know, we're also earning, you know, quite a bit higher interest rate than we have historically. But, you know, we'll continue to, you know, ultimately return the cash to our shareholders in, you know, the most opportunistic way.

Jerry Revich (Senior Investment Leader and Head of U.S. Machinery, Infrastructure, and Sustainable Tech Franchise)

Thanks.

Operator (participant)

Thank you. There are no further questions at this time. I would like to turn the floor back over to David Graziosi for a closing comment.

Dave Graziosi (Chairman and CEO)

Thank you, Alicia. Thank you for your continued interest in Allison and for participating on today's call. Enjoy your evening.

Operator (participant)

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