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Navistar International Corporation (NYSE:NAV)

Q2 2009 Earnings Call

June 9, 2009 10:00 am ET

Executives

Heather Kos – Vice President of Investor Relations

Daniel C. Ustian – Chairman of the Board, President & Chief Executive Officer

A.J. Cederoth – Interim Principal Financial Officer

Archie Massicotte – President Navistar Defense

Analysts

Jerry Revich – Goldman Sachs

Henry Kirn – UBS

Ann Duignan – J. P. Morgan

Patrick Owen – Deutsche Bank

JB Groh – D. A. Davidson & Co.

Kirk Ludtke – CRT Capital Group

Walter Liptak – Barrington Research

Brian Sponheimer – Gabelli & Company

[Chris Edwards – Jefferies]

Operator

Welcome to the Navistar International Corporation second quarter earnings release. Today’s call is being recorded and for opening remarks and introductions I’d like to turn the program over to the Vice President of Investor Relations, Heather Kos.

Heather Kos

To start with, here’s our Safe Harbor statement. Information provided in statements contained in this presentation that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as Amended, Section 21E of the Securities Exchange Act of 1934 as amended and the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements only speak as of the date of this presentation. The company assumes no obligation to update the information included in this presentation. Such forward-looking statements include information concerning our possible or assumed future results of operations including descriptions of our business strategy. These statements often include words such as believe, expect, anticipate, intend, plan, estimate or similar expressions. These statements are not guarantees of performance or results and they involve risks, uncertainties and assumptions.

For a further description of these factors, see item 1A risk factors included in our Form 10K for the year ended October 31, 2008 which was filed on December 30, 2008 and item 1A risk factors included with our Form 10Q for the period ended April 30, 2009 which was filed on June 9, 2009. Although we believe that these forward-looking statements are based on reasonable assumptions, there are many factors that could affect our actual financial results or results of operations and could cause actual results to differ materially from those in the forward-looking statements.

All future written and oral forward-looking statements by us or persons action on our behalf are expressly qualified in their entirety by the cautionary statements contained and referred to above. Except for our ongoing obligations to disclose material information as required by the Federal Securities Laws, we do not have any obligations or intentions to release publically any revisions to any forward-looking statements to reflect events or circumstances in the future or to reflect the occurrence of unanticipated events.

Other cautionary notes, the financial information herein contains audited and unaudited information as prepared by management in good faith and based on data currently available to the company. Certain non-GAAP measures are used in this presentation to assist the reader in understanding our core manufacturing business. We believe this information is useful and relevant to excess and measure the performance of our core manufacturing business as it illustrates manufacturing performance without regard to selected historical legacy costs, i.e. pension and other post retirement costs.

It also excludes financial services and other expenses that may not be related to the core manufacturing business. Management often uses this information to access and measure the performance of our operating segments. A reconciliation to the most appropriate GAAP number is included in the appendix of this presentation. Now, I’m going to pass it on to Dan.

Daniel C. Ustian

Today we’ll talk about the second quarter, we’ll give you an outlook for 2009 and then give you a picture of things that are going on in 2009 that will affect 2010 and beyond. But, before I do that in the last six weeks I guess, we lost a dear friend and a colleague Terry Endsley to cancer and as you all know that are familiar with Terry, he was a great asset to us all and a great friend.

One of the things he did though was he developed others and one of those, he did help develop as A. J. Cederoth. A. J. Will be with us today taking Terry’s spot for that. A. J.’s background was he worked in operations, worked in the engine business in several different places, he worked in our treasury, he was assistant treasurer and he was the treasurer of the finance corporation so he’s got a great background for us as we move forward. So, welcome A. J.

On Slide Five if you can try to follow in the package, Slide Five, four panel chart you can see that the industry continues to be very difficult. In fact, it’s as low as it’s been in many, many years. If you look down at the bottom on revenue, you can see that our revenue is down as a result of that in the second quarter by about $1 billion, we’re at $2.8 billion.

Now, if you look at the profits on the right side of the page, if you remember in the first quarter we had discussed two levels of profits, one we would call operational and one that’s accounting. The difference really is because of a settlement we had with Ford Motor Company and in the first quarter that was a positive influence of $190 million. We stated at that point that there was going to be some pluses and minuses through the rest of the year and in the second quarter that was a minus of about $38 million. So, we’re going to have to present it both ways throughout this year so those two panels on the right side reflect $125 million of segment profits without that and $0.60 a share without the one-time costs of that and that’s the way we measured the first quarter and we’ll try to measure ourselves the same way all year long.

On Slide Six, you can see the markets continued to be extremely tough. We thought ’07 and ’08 were tough years coming down off of ’06 but as you can see the second quarter was off about 40% from last year’s second quarter in terms of vehicle shipments. On the right side of that you can see engine shipments were down as well not just from Ford, Ford was down as well but throughout the globe.

If you look down at the panel on the left hand side you can see that we look at the parts industry and this is a difficult one to measure because the data is not all that available but we believe it’s about 14% off and yet we have had some share improvement and I’ll talk about that a little later so it didn’t affect us as much as that. If you remember, our goal was to be profitable at all points in the toughest of markets and as we all know this is clearly one of the toughest markets that we’ve experienced and we’ve found ways to be profitable.

On page seven, one of our ways is our presence in the market place. As you can see we continue to be number one in school bus and medium truck. Our share is slightly up from last year, it’s about right where we want it to be on both school bus and medium trucks. But, on severe and heavy we’ve made significant improvements and we’ve continued to make significant improvements and in the second quarter we had 36% share in severe service and 23% share in heavy truck. Overall, you can see we’ve gained six points in share in the North American market from ’07 through the second quarter cumulative ’09.

On Slide Eight it depicts our reported earnings. The settlement affects I spoke bringing us to $0.60 a share. I want to point out some other significant information that’s related to the second quarter and one of those is in R&D. We continue to invest in R&D. In the second quarter we spent $130 million in R&D, up about $31 million from prior quarters and from last year as well. Those are related to 2010 emissions, to MATV investments to MRAP investments. So, we continue to invest in our future. That’s still our strategy. We’re going to continue to invest in our future and take advantage of things.

So, those were all planned. One area that wasn’t plan that is a disappointment and that is a preexisting warranty. We were hit by $45 million in the second quarter. Obviously, if you take that out we had operationally over $1 a share and a really strong quarter but we were affected by engine warranty which surprised us a bit. If you look at Slide Nine, these are two charts that we use internally to track where we are in quality. Repairs per 1,000, that’s a typical industry thing and in fact, automotive uses that and you can see from that chart that our trend is very strong.

The quality of our products is better and in fact, one of our targets was to have repair per 1,000 equal to a pre electronic engine, going back to 1994 and that’s really how the legend, the [DP] was established based on the quality we had back then and of course that’s a mechanical engine. So the complexity of that product versus today is much different so we felt that’s a great target to be at and we achieved that. You can see the cost per engine warranty has gone down commensurate with that.

The surprise came in, in that the cost to repair is up in the second quarter and what happens with that is when that cost of repair goes up in a quarter you have to reflect that across all the population that is out there. So, it’s not a big number in the second quarter, it was $3 million. It increased by $3 million in cash but, now if you take that across all of the products that we have out there, some warranted for three years and some warranted for five years, it extends out to be a significant $45 million hit that we took.

Now, what can we do about it? Well, obviously we have to reduce the cost of repair and continue to reduce the number of repairs. But, let me just give you some examples of the complexity of the end products today, a sensor could go out and you’ll need to replace an entire exhaust unit, thousands of dollars, or an injector system, thousands of dollars. So, we have to continue to work on that to mitigate what is reflected in the second quarter results. We’ll keep our eye on it and we’ll keep reporting to you on our progress on that. But, I can assure you the quality of our product is outstanding, it’s just the cost to repair when we do have a challenge we need to continue to get better at.

On Slide 10, this is a very similar slide to what we showed you in the first quarter and we said we had a positive effect in the first quarter of $190 million related to the Ford settlement and that by year end it was going to be somewhat less than that. In the second quarter that was a $32 million negative. There’s nothing in there that is different than what we expected but, by the year end we’re not changing where we expect to be. We did get this approved by the Department of Justice in May so now we can conclude that and get the benefits derived from this settlement with Ford in operational items for the rest of this year. So, there’s nothing different with that it’s just the quarter was affected by it and we’ll see the other part in the third and fourth quarter be positive.

Now, let’s talk about the rest of the year and where we are, Slide 11, I don’t have to tell you the industry is strained. In fact, where we see it today it’s as low as it’s been in 45 years. If we go back to the last cycle in 1991 that was at 225,000 industry and we’re projecting it to be 165,000 to 185,000 so these are some challenging periods in the trucking industry. On page 12 now we’re reflecting where we are based on that and we’re saying that we’re going to be about a $12 billion revenue company this year and that will include as an industry somewhere 165,000 to 185,000 in trucks.

To give you a barometer, the first half of the year was 92,000 so to make the high end of that it would have to be about the same as the first half and I’ll just tell you the second quarter was lower than that as far as the retail number. The first quarter showed some signs of recovery and the second quarter went back down again. Now, just some ad hoc things, we’re seeing our customers say they think they’ve seen the bottom and we’ll talk a little bit about freight in a little bit but they’re seeing it come back just a little bit.

On the engine side, we shipped 115,000 total engines in the first half of the year and we’re projecting that pace to increase a bit. But, you must keep in mind two things, we had 10 weeks of down time related to Ford in the first half. So, we didn’t ship anything to Ford for about 10 weeks. That was an inventory adjustment included in that. So, we expect that and we’ve got relatively firm schedules on that so we think we’re comfortable with 255,000 to 275,000. The other positive factor is we’re seeing some improvement in South America which has become a bigger player for us so we’re relatively comfortable that we’ll be able to meet those shipments that are out there.

When you look at Slide 13, it kind of depicts kind of what’s going on in the economic conditions and freight continues to be challenged as reflected by this chart. April and May we would expect based on just some ad hoc discussions with our customers it will go back up a little bit but you can see some of the indicators are positive. On the diesel price versus gas prices, you can remember when prices were $4 and $5 a gallon and diesel was a $1 a gallon higher. Today, they’re about the same, in fact, maybe sometimes like right down the road you can see that diesel is actually lower than gas now.

Now, that helps our customers, especially the smaller ones and as a result of that the carrier failures has gone down illustrated on this chart, to a containable level. This is more normalized now so in the first quarter it was 480, I know that sounds like a higher number but that’s not unusual to have that number of carriers fail. On the right hand side you’ll also see the average age continues to increase so the need for buying new vehicles is clearly there. At the bottom of the page our dealer stock is very low so when the market does come back we’ll be able to respond quickly to that.

On page 14 we’ve put a chart in here just to kind of show you what’s happening to our production schedules and what we tried to do is we tried to level our production schedules throughout a period. It helps in quality and it helps in cost. You can see on medium and bus in spite of all the challenges in the markets and the ups and downs, we’ve been able to do that. They’ve been relatively flat all year long and we continue to see that as our projection for this year.

Severe service, we’re down with MRAP now, at least for this order so therefore that schedule has come down and we would anticipate that now staying flat through the rest of this year. Heavy though is probably the one that’s been affected the most by it and we brought that schedule down fairly dramatically at the end of last year and it stayed about that level for the rest of this year.

Commodities has been relatively contained. You can see from this chart it’s about the same as we projected last time. It’s obviously significantly lower than the peak of last year and even lower than 2007 so at this point in time commodity costs seem to be very contained. So, all that drives us to page 16 and if you look at our guidance from 3/11 our objective always is to try and find ways to mitigate the volume challenge that’s out there and we did that in the first quarter by other actions and we’re trying to do the same theory at this projection.

You can see volume is off from our projection last time to this time by 40,000 units in the industry, about 30% so obviously, a significant change. We’ve talked about the warranty challenge so we’re trying to find other offsetting actions like continuation of improved cost reductions, the impact of Blue Diamond, military revenues of somewhere between $2.7 and $3 billion, market share improvements both in vehicles and in parts and then further control of SG&A which then would bring us to $2.80 to $3.10 plus the restructuring settlement with Ford so our total will end up being $5.20 to $5.50. I should point out that doesn’t assume any MATV, if we do win that it would probably go up a little bit based on the volume that we would have in this year.

On Slide 17 now, this is a chart that we’ve shown for a long time and before the economic challenge that we’ve experienced now in the last 18 months, the industry felt 2009 would be a good year and 414,000 units would be about what the industry would sell. Obviously, we’re significantly below that. We had a goal of $1.6 billion. You talk that and extrapolate it down to the volume range we are now you can see it wouldn’t be an acceptable level so we have counteracted that to with other measures to bring us to a segment profit excluding the settlement of about $750,000 million in manufacturing profits.

We feel we’re addressing the challenges in the marketplace but there’s still more opportunities. So, if you could take Slide 18, if there’s a way that you can set that aside because I’d like to talk about each one of these things that we need to accomplish in ’09 that bodes well for ’10 and beyond. The first one is presence in the marketplace, you can see Class 8 continues to improve in our presence. Certainly, the ProStar has been a big factor in that and the quality of our products as related to it.

Our order share continues to be even stronger than our retail share. We would expect that to flatten out but still be very strong going in to 2010. On the cost side of heavy, look at page 20, if you look at the two red dots, that’s where we manufacture Class 8 vehicles today in Mexico and in Canada in our two operations there. Logistics can cost as much or even more in and out than putting that vehicle together. So, what has transpired is many of our suppliers have moved from the Midwest down in to the southwest and even in to Mexico so now that poses a challenges for our cost structure.

Also, our competitors now have brought some of those suppliers with them by moving in to that area. So, we’re reevaluating this and we’re looking at where we should manufacturer. The third point to make here is now we’ve attracted new customers and a lot of them in the southwest and the western areas. New customers including Swift, Knight, Warner, Creek, England, [Bigsby], [Canasaw], all these are new customers in those areas that now we believe we have to service from a different place.

So, our strategy is and the labor negotiations are going on today with the CAW, the contract is up at the end of this month. What we’d like to do is to service Canada and the northeast from our Chatham operation with all vehicles for those markets and serve the rest of the country from Mexico. If we can accomplish that there’s significant savings related to doing it that way. That’s the plan and you’ll see an action to that by the end of this year.

Slide 21, on 2010, it’s an enormous opportunity for us, there’s been a lot of discussion on this, you can the cost related to this for all of our competitors is a lot higher than ours. There have been indications that the cost price could be as much as $10,000, this is our competitor speaking. Obviously, we’ll price competitively and our cost is significantly less than that so a great opportunity for us to improve our margins as we go in to 2010.

The strategy itself, our environment strategy itself enables us to be able to capture this improvement. Our strategy, and we go back many years for this, is to have the environment be invisible, the changes for 2010 or any other year, be invisible to the customer. We’ll be responsible for that. Now, for us to be able to do that we put together a strategy with the Environmental Protection Agency that said we could take more time to get to point two as long as we got to point five by 2010.

That’s been our strategy all along. We have taken technologies to get us there. We have the highest injection pressure system anywhere and we have the only twin stage turbo that’s out there in the Class 8 market today. That including proprietary combustion [bowl] gives us an opportunity to meet emissions without any other after treatment. On the right side of the page it’s a similar concept. We have been out working on vehicles, hydraulic hybrid vehicles, electric hybrid vehicles. In fact, we’re going to have an all electric vehicle somewhere in the near future.

We got out in front of this when it wasn’t so fashionable. Now, the market place is getting stronger for that. You can see government policies are being aggressive on this and we’re prepared for that. So, our environmental strategy is always get out in front of it before you have to do it. Now, on Slide 23, this also supports this strategy, these are certifications of the EPA that’s out there today and on the left side is our medium duty range engines and on the right side is the heavy.

You can see from this versus our competitors we’re already a long way there towards meeting the goals. So, what they have to do is come from let’s say 1.8, 1.9 down to .2. We’re going from .9 to .5. So, this is not a dramatic change for us. In fact, everyone will also have a startup, we won’t have really a start up. I mentioned the changes on the prior page about fuel and air, those are minor changes that we’re tweaking through our system so for 2010 we will not have a major startup to go through.

Some of the other things going on, Slide 24 will talk about some of the other markets we’re getting in to and remember, by the end of this year we will have new products in India through our Mahindra operation. The India market has not dramatically changed like the rest of the world has, it’s gone down I think about 6% so they still have reasonable volume there. By the end of this year we’ll have products in there and in 2010 in we’ll have a presence there.

The same thing can be said about our relationship with Caterpillar, the joint venture with the, first we’ll have product being designed and developed next year for 2011 for the US and then the rest of the world we should be able to sell product next year leading up to an obviously lot higher volumes as we go forward but, next year we will sell some products through our joint venture through the rest of the world with CAT.

Slide 26, where we’re most successful is where we reach the end customer. We’re most successful not only from the customer standpoint but from our profitability. The acquisition of Monaco’s assets, and that’s what it was, allows us to get to the end customer. If you look at Slide 27, this is what the deal is, we paid $47 million for inventory, that’s what we bought. Part of that deal, we have the manufacturing facilities, the trademarks, the intellectual property, etc. to run this business.

The picture at the top are the products that we manufacturing. You can see the industry is incredibly strained today even more so than the trucking industry. We have a breakeven or slightly profitable plan in place already even at the lowest points and we believe as this market returns with the synergies that we have, we can have an extraordinary business there going forward, one that’s $1 billion plus for the inventory of those assets.

On Slide 28, it also brings some other features with this. When you look at our bus business for instance, we’ve always been successful in the marketplace in buses but we were never real profitable until we controlled to the end customer. So, we brought the value added and that’s the same strategy we have with integrating Neobus, the motor coach opportunities with Monaco and with our own bus business. So, we’re going to be having commercial bus applications and motor coach applications utilizing the assets that we have between Neobus, Monaco and ourselves and we’ll talk more about this in the future. But, a significant opportunity for us to be very competitive in those.

On the military side we’ve always said we have a $2 billion that’s containable. That has certainly been exceeded over the last couple of years. I do want to point out on Slide 30 that the MRAP now is complete, at least from the orders that we have but we still have all this other business. In fact, 74% of our orders have been in this kind of business. Now, they’re not $500,000 vehicles but there’s a strong business to support that.

The second half of the year if we get no other orders we’ll have about $1 billion in the military business from those types of vehicles excluding any large MRAP or MATV vehicles. So, if you looked at page 31, we’ll talk about a building block of orders that we already have that could build in to something else in the future. One of them is with the UK, it’s called a TSV vehicle, Archie is sitting out in front of me here and this is really the kind of vehicle we had in our mind to start up our business.

We love this vehicle and the UK is buying 262 of those with the opportunity for that to be transformed in to a lot higher volume in the future. In the market place we will make these starting in July of this year. It probably won’t reach Afghanistan until the fall but I’m going to tell you they’re going to love this vehicle.

In Canada, we have orders from the Canadian government for medium vehicles. We can see that expanding as we go forward in to next year. That’s for 1,300 units that we have. In Taiwan we’ve delivered 260 units. There are many more opportunities. In Singapore, all the lists that we’ve talked about in the past, to take these kind of vehicles and bring them forward. Two major programs that we’re bidding on today, one is the MATV. We love our vehicle here as well.

We think we bring many of the needs to the government like our ability to manufacturer quickly, like the quality that we can bring. But, we’re still in the bidding process. We should know this over the next month or so. As you probably saw recently, Mr. Gates increased the buy on this in the short term from 2,000 to 5,000 so this is a significant amount of business for someone and we know we’re in the mix.

[Inaudible] is another one, this is a bid that is going on right now that will be probably for production in late 2010 and beyond. It’s right in our wheel house, this is what we do. We think we’re very competitive in that and again, it’s a bidding process that we should know in the next 60 days on that one. So, the military will continue to be strong. Keeping in mind, without those, we still have a $2 billion business and we’d like to at least get one of those, if not both.

Finally, let’s talk about engines here because engines has transformed this business. We went [inaudible] as you all know at the end of this year and we’ve been on a path to offset that with growth in other areas. Certainly one of those areas is making our own Class 8 engine, the MaxxForce 13 is out there in small volumes. As 2010 comes along obviously that will get a lot bigger but we also are developing a 15 liter engine that uses the same components, the technical components of the 13 and marries it up to the structural part of the Caterpillar C15.

So, it allows us to get in to that market quickly with proven technologies and that will be available by the beginning of 2011 but we’ll have it in our customers’ hands a lot sooner than that. As far as the engine business growth, we continue to grow and in fact in the second quarter we had a new customer Daewoo for about 15,000 a year, we have tractor engines for about 20,000 a year and then we have consummated an agreement with General Motors to continue with them and that could be as much as 50,000 a year all coming out of South America.

We’ll talk more about this as we go forward but suffice it to say that we have a business that is strong in spite of the fact that the Ford business will be dissipating at the end of this year. So, as you can see from that we’re looking forward to completing 2009 strong and the number of things we have to do in 2009 to get a 2010 that’s even better than this year is right in front of us here. So, A.J. if you could talk a little bit about cash and finance.

A.J. Cederoth

What I will try and do here is take a look at where we are with cash both at the manufacturing company and as well at the financial service company, primarily Navistar Financial and then tie that in to 2010 and our outlook on how this all fits together. On page 36, just to kind of get grounded with where we were with cash, we closed the year with $777 million of cash and what’s on this page but we had that cash declined in Q1 to $582 million. So, from Q1 to Q2 we’ve improved cash slightly to $594.

Again, results from operations had a positive influence on our cash offset by some capital spending and some share repurchase programs that occurred in Q2. When we look at our outlook for cash, our goal for the year, we’ve put a range here of $600 to $700 million. I’m more optimistic that we’ll be at the higher end of that range. We have lowered it from our previous goal that’s primarily a result of the lower truck cycle. We will manage our capital spending around this point in the truck cycle and keep that at the low end of our range consistent with where we were last year and we’ve really developed a focus on working capital efficiencies so we can drive every dollar to the bottom line and be more effective with our working capital.

Dan touched on a few opportunities for 2010 that are not in our forecast primarily around military orders. It’s important to remember that if we are successful with these military orders we will need to stage material ahead of these orders and that will be a temporary drag on working capital. The manufacturing company’s capital structure we continue to benefit from a low interest rate environment. This facility is in place through 2012 so we really don’t have any activity against that in the near term going forward.

If we turn to page 37, with financial services, Navistar Financial has good liquidity, over $1 billion of liquidity. If you take a look at where we are at this point in the cycle with Navistar Financial, our balances are low but our portfolio has stabilized. That allowed us to have a good quarter here in Q2 and we expect to be profitable for Navistar Financial for the remainder of the year. They continue to access the market, they’ve closed the retail securitization in Q2 for $300 million. We’re optimistic that the government actions around the TALF program will improve the securitization markets and we’ll look to reenter the public markets on securitization before the end of the year. Our primary bank facility matures in July of 2010 and we’ve already begun to develop strategies with our bank groups on how we can refinance that in the most cost effective way.

Dan showed this page earlier on page 38, our goal here would have been to have $1.6 billion of segment profit against a market of $414 and if we work down this line you can see at this point in the cycle results would have been dramatically lower. We’ve improved that and we’ve talked about our guidance of $2.80 to $3.10 per share but when you translate that in to cash what that’s done is it has allowed us to continue to invest in our strategies, continue to make prudent capital investments. We’re very focused on working capital so we can be efficient at the bottom of the cycle. It’s allowed Navistar Financial to maintain its liquidity and overall we’ve got a very strong cash balance for this point in the cycle which gives us confidence that we can continue to make our investments for 2010 and beyond.

When we look at 2010 on page 39 starting from the base of the industry we think that the market recovers in 2010. How much that recovery is right now no one’s really sure as to when and to how much but we think the market recovers and we think we maintain if not improve our market share. All of that should help the results of the company. If you take a look at the strategies that we have in place both around 2010 emissions and the acquisition of Monaco. Those things will help our numbers as we look to 2010.

We talked about the government approval of the joint ventures on Blue Diamond. We’ll have a full year effect of that impact on our business in 2010 which will improve results. We’ve got growth strategies that are in place, Dan touched on the positive things going on in the engine business but we also have the impact of the Mahindra joint venture and the CAT joint venture. All of those items will start to improve results as we move forward.

We see our military business stabilizing around a $2 billion business but we’re also optimistic that there will be new opportunities there. Exactly when those happen we can’t predict at this point but we’re optimistic with our military business. Commodities play a big part in our cost structure, we’ve been aggressive in managing commodities in 2009. We need to continue this in 2010 but we also need to recapture any commodity movement in our pricing strategies in the market place.

The final item is post retirement cost, always a challenge for Navistar to manage the post retirement. We work on this every day, we’ve got some plans in place. We think this will be neutral for 2010 but we’re continuing to work on that. Overall we think 2010 we can improve the results. We’ll have a clearer picture for this on our next call.

With that Heather if we want to open up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jerry Revich – Goldman Sachs.

Jerry Revich – Goldman Sachs

Dan, you mentioned that Archie was on the line, Archie I’m wondering if you can discuss whether you plan on competing for the ECV II recompete and where do you see the timing on that program?

Archie Massicotte

Sure. For sure we are going to compete for ECV II. Well actually Humvee replacement, that’s the AM General Humvee as we know it today. The military made a comment recently that said that they’re going to compete it rather than go to a sole source contract. We are definitely going to compete for that, we’re already working on some design proposals as to what we can bring to the table for that. That is one of our targets for sure.

Jerry Revich – Goldman Sachs

Archie, how is the timing on that bid look like? Do you have a sense for when the RP will be formerly out and when the decision is going to be made?

Archie Massicotte

I don’t have that intelligence right now. I would anticipate though, this is purely guessing, I think probably latter part of this year possibly in to the first quarter of next year.

Jerry Revich – Goldman Sachs

In terms of a decision being made?

Archie Massicotte

By the time the RP gets written and submitted and go through the evaluation process it probably won’t occur to sometime mid 2010.

Jerry Revich – Goldman Sachs

Archie, you alluded to the inclusion of mine resistant vehicles on the future combat system platforms, can you talk about how you see the military’s target allocation for mine resistant vehicles and the total tactical vehicle fleet going forward? Do you have a sense, are they thinking 5% of the total fleet, 10%, how are you thinking about that?

Archie Massicotte

I think that’s still being rejuggled right now within the Pentagon. As you know, Mr. Gates has gone back and relooked at the whole acquisition of wheeled vehicles as well as other systems that the military is using. They’re trying to figure out what their next strategy will be as they look at the replacement of such vehicles including FMTV and other programs that are out there. We are poised and ready and I’m going to express the fact that this fits our wheel house very well with where they’re trying to go. That has not been confirmed yet as to what their strategy will be long term but we are aggressively on top of that and we will be watching that very closely.

Jerry Revich – Goldman Sachs

Then you mentioned on the Monaco acquisition at the current industry run rate you’re able to get that business to breakeven. I’m wondering if you can step us through the major operational changes that you’ve made in that business that allows you to run it at breakeven at this point? Also, you mentioned that $600 million revenue potential in 2011 at the low end, I’m wondering if you can comment on what kind of margin structure you expect there?

Daniel C. Ustian

First of all Monaco themselves did some restructuring even before we came in. So, they had downsized their facilities and their people pretty dramatically. Then, you take the back office, you take all the back office that they needed as a private company and you dump it in to our company, you don’t need the back office anymore, we already have it so we’ve streamlined that. Then thirdly is the supply base, we’ll be able to buy off our supply base, they’re the same suppliers that we use so we’ll have the scale together to be able to reduce the cost structure of that operation and we feel we’ve got a really nice little niche business here that will separate us from all the people in that market place. What was the question on 2011?

Jerry Revich – Goldman Sachs

You mentioned in your slides that you can get to $600 million to $1 billion run rate in that business, I’m wondering at the lower end of that range what kind of margin do you think you can get to?

Daniel C. Ustian

Well, we’ve said on all of our businesses we need to target 10%. I don’t know what that point is where the industry has to be at to get 10% but it’s on the lower end of that not the higher end.

Operator

Your next question comes from Henry Kirn – UBS.

Henry Kirn – UBS

I was wondering if you can talk a little bit about some of the sign posts that give you a view as to where 2010 demand could go. Then, maybe dovetailing with that if you can discuss the parts business in a little greater detail and if that business is one of the businesses that would allow you to anticipate shifts in demand?

Daniel C. Ustian

Well, let’s dissect it a little bit in to each of our businesses first, the bus business let’s talk about what the influential factors are, in the bus businesses buses is typically relatively flat anyway and we’re expecting it to be flat but there are some incentives out there. That could influence it somewhat positively because of the aid and some of the packages available in the stimulus so we would expect bus to be a little bit higher because of that. On the severe service side if there’s one area that the money is getting to it is in the construction area so we’d anticipate that money floating through by the end of this year and the severe service industry ought to pick up.

Medium trucks, this is slower. We think that on the medium truck side until home building comes back and more of the consumer type businesses come back this is going to stay slow so we’re looking at least another six months on that. On the heavy side it will be influenced of course by what the goods move so the overall economy will be the influencer there and your guess is as good as mine. They have to buy, the need to buy, there will be some pre buy this year, it will all be dependent on where the overall economy is as to how much of that buy will occur this year and in to next year.

On the parts side we’re seeing it to be flat. It’s all dependent on utilization of the vehicles that are out there and as you all know until the economy picks up the utilization will still be flat. We have picked up some share through aggressive actions on our part. Military part has been strong and will continue to see that be strong to support the vehicles that are out there. So, for us parts continues to be a good story.

Henry Kirn – UBS

Is it possible to talk a little bit about some of the factors that could allow engine profitability to improve over the next couple of years?

Daniel C. Ustian

We’ve changed from being focused on automotive to all the other areas including niches but, the first one of course is to support our own vehicles and now we’ll have engines across all of our vehicle platforms and obviously Class 8 is the biggest one that is out there. We’ve got to make sure that MaxxForce 13 and 15 are done right. But, the V8 and the [BP] there’s very little change to that as we go forward so we think there’s a great opportunity for us not only in the engine side but to sell more vehicles in those platforms because of our strategy on AGR versus SER.

If you look at South America, South America has become now more of a focal point for us in terms of engine build and last year we shipped almost 150,000 engines there and we’ve added some customers. Now, the volume will be down this year because of the global economy but we continue to get more and more business related to the product that’s there and the markets that are there so we would expect another 50,000 units coming that way as soon as all that market returns related to the South American products.

Finally, Blue Diamond parts, we now have 75% ownership in that. You can see that it is a successful business, it’s in our 10Q I believe, I know it’s in the 10K, that that business makes about $180 million a year, $160 to $180 million a year and we’re going to have 25% more ownership in that business going forward to support parts business coming out of diesel and Ford mid range truck products. So, those are the influences for us in 2010. We think they’re all positive.

We mentioned that the post retirement costs we continue to work on. It was a drag for us this year, we’ve made some progress so far and we’ll continue to work on that to try other avenues that we can get that more under control. I think A.J. also mentioned that the funds now a little stronger than they were six months ago that helps us a little bit too but, we’re not out of the woods on post retirement costs.

Operator

Your next question comes from Ann Duignan – J. P. Morgan.

Ann Duignan – J. P. Morgan

Could you talk a little bit about transitional inventory that you may have to build from now to the end of the year on engines. I think you said that you don’t expect the 15 liter to be ready now until 2011, did you mean calendar year 2011 or fiscal year 2011? How are you going to bridge the gap then between January 1st and that point in time?

Daniel C. Ustian

Well, there’s a couple of things that occur with that, first our 13 liter will help us do that. There will be some transitional engines that us and our supplier is working on. We’re not ready to talk about that publically yet but the transitional [inaudible] have engines this year that we can sell in to ’10 and all the engine manufacturers and the truck manufacturers are doing similar things. So, we’ll be able to close that gap. It’s not all the way closed yet and we have some plans on how to do it and your point is we still are not there I know but, we’re making progress on that to close that gap up so we don’t have any void.

The other factor we believe is that the 13 liter, as soon as it gets out there in more volume our customers will be more comfortable with the 13 liter and we really don’t need a 15 liter in many of these applications with a good 13. So, there will be some transition there from 15 to 13, you get benefits from that in terms of weight, in terms of fuel economy by having a smaller product. So, some of that will transpire here over the next six to nine months.

Ann Duignan – J. P. Morgan

Just following up on that I just wanted to dig a little bit deeper, in your outlook for cash for $600 to $700 million, how much have you assumed in terms of inventory build in that number?

Daniel C. Ustian

We haven’t said that publically but it’s a big number, I can assure you with all the engines we have plus the supply base, it’s a pretty significant number.

Ann Duignan – J. P. Morgan

But it is included in your outlook?

Daniel C. Ustian

It is included in there yes.

Ann Duignan – J. P. Morgan

Then just following up on what you said that you haven’t really closed the gap all the way yet for next year, how concerned should we be about that?

Daniel C. Ustian

Well, you shouldn’t be concerned. There are different ways to do it obviously, the best one is to be ready earlier and we have found ways to close that gap up. In fact, by the end of this year we have found ways to be able to get that engine out in customer’s hands. So, we continue to work on that and until we get firmly entrenched in how we’re going to do it Ann I’d be remised to say that in this environment without especially talking to our customers first about it. So, we continue to make progress on it and we’ll have a solution.

Ann Duignan – J. P. Morgan

But the 15 liter you have at least a couple of 15 liters out there in customer’s hands, is that what I heard?

Daniel C. Ustian

By the end of this year, yes.

Ann Duignan – J. P. Morgan

By the end of this year but not yet?

Daniel C. Ustian

Right. We have some, our own in the Dynos but not in customer’s hands yet.

Ann Duignan – J. P. Morgan

So by the end of calendar year ’09 you’ll have some out there?

Daniel C. Ustian

Right, that’s right.

Operator

Your next question comes from Patrick Owen – Deutsche Bank.

Patrick Owen – Deutsche Bank

Just two questions first, what level do you think your R&D is going to be at for the full year?

Daniel C. Ustian

The rate will come down, I’m not sure we’ve said what that will be but, the rate will come down in the second half and that’s because programs like the military programs I talked about, those will be behind us, the emissions programs for ’10 those will be behind us so that rate will be at a different rate. I think the first two quarters were $230 million, something like that and it will be at a lower rate than that for the second half.

Patrick Owen – Deutsche Bank

Dan you said you expect the order rate to even out in that 30% range that you’ve been running at. What are your current thoughts on what the sustainable Class 8 share is? You had previously said it was that mid 20% range.

Daniel C. Ustian

Patrick, we still think that it is in that range. For us to balance out price and used truck inventory and our ability to finance these we think really it’s in the mid 20s is where we’re going to end up. Now, I hope we do better than that and maybe with our strategy for AGR maybe it will end up with that. But, our plans are to be in the mid 20s, that’s as high as we expect to be.

Patrick Owen – Deutsche Bank

Does the improvement in the securitization market make you feel better about your ability to finance those?

Daniel C. Ustian

A.J. what do you think?

A.J. Cederoth

Well certainly, as the securitization market comes back that gives us access to a lower cost source of funding so that improves our competitiveness in the market place with our products.

Patrick Owen – Deutsche Bank

Just lastly on the warranty expense, basically all of the existing warranties you have out there were basically marked with what the level of the service cost was in the second quarter so there won’t be any further charges going forward unless costs go up again?

Daniel C. Ustian

That’s the way it is. We were hoping you’d forget about that question. Just another point, we did the same thing on the used trucks, we took some write down on used trucks in the second quarter commensurate with what’s going on in the used truck market so again if the market stays where it’s at we’re fine with that. Hopefully, it will go up and we’re trying to put actions in place that gives us more places to find used truck customers.

Operator

Your next question comes from JB Groh – D. A. Davidson & Co.

JB Groh – D. A. Davidson & Co.

I don’t want to harp on the warranty cost question but I will. Is there any specific model there, is it related to Ford, how should we think about that?

Daniel C. Ustian

No, it really isn’t. It is in the repair of all of our engines and if you think about it a minor problem, let’s say a sensor goes out, it could take a whole turbo system out that is a couple of thousand dollars. So, the answer to it is we’ve got to get diagnostics in quicker so you can do a calibration change for instance instead of replacing six, eight injectors or a whole air management system that is very expensive. So, it was something that we don’t follow on a daily basis that that’s going to change. We do follow the hours and all that and in fact we have meetings every morning to track what happened yesterday in terms of the quality of the product.

But, this cost, we don’t have the systems in place yet to track what’s going on with it and we’re in the process of doing that so we can get an idea quicker. But, we were surprised by the level of cost per repair that went on in the second quarter.

JB Groh – D. A. Davidson & Co.

Then on these potentials of the MATV and the FMTV, is there any additional cap ex that you’d have to do related to winning one or both of those programs?

Daniel C. Ustian

Minor things, keep in mind our strategy is taking things that we already have and utilizing them so there’s not much here. It will be insignificant or certainly you won’t see it.

JB Groh – D. A. Davidson & Co.

Then on the pricing on the FMTV probably as you said they’re not $500,000 vehicles but should we consider the pricing their more like a commercial vehicle or is it a little bit higher than that?

Daniel C. Ustian

Well, there’s more on it so it will be more than that.

JB Groh – D. A. Davidson & Co.

And it’s a bunch of different types right, not all 12,000 are the same?

Daniel C. Ustian

Right.

Operator

Your next question comes from Kirk Ludtke – CRT Capital Group.

Kirk Ludtke – CRT Capital Group

I just wanted to follow up with Archie on a couple of military topics. Just to be clear, on the MATV, do you still think it will be a sole source are you think that there may be more than one player there?

Archie Massicotte

Well, it was headed that way and I think when the volumes got adjusted to the range of around 6,000 vehicles, I believe that there is serious consideration of going to two sources.

Daniel C. Ustian

I’ll just remind you we have always said we felt it was going to be two sources even though they’ve always said that it was going to be one source. So, we haven’t changed on this.

Archie Massicotte

That’s fair but I believe the volume impact right now and the urgency I think is probably going to steer them to two sources but that tail is yet to be told.

Kirk Ludtke – CRT Capital Group

How many players are left? How many teams?

Archie Massicotte

Five right now.

Kirk Ludtke – CRT Capital Group

Then the FMTV, I guess there’s multiple contracts in that category as I understand it, is that fair to say?

Archie Massicotte

Well, it’s one major contract for multiple different variants.

Kirk Ludtke – CRT Capital Group

Do you think that will probably be multiple sources as well?

Archie Massicotte

No, I don’t believe so at all. I think it will start out that way but ultimately I think it could evolve down to one.

Kirk Ludtke – CRT Capital Group

How many players do you think are left there?

Archie Massicotte

Three.

Kirk Ludtke – CRT Capital Group

Then switching gears to the emission topic, when do you think you’ll need to get to the point two? I know you’ve got some flexibility with your emission credits but it seemed like it was a bit of a moving target as to how many credits you’d have, how quickly they’d be consumed. When do you think you need to be at point two?

Daniel C. Ustian

Well, our plan is to not launch everything at one time to go to point two. So, we’ll do a couple of years, maybe even sooner than a couple of years on some products and then two to three years ultimately for all the products.

Kirk Ludtke – CRT Capital Group

So you’re still in that 2012 timeframe or maybe even further out before you actually have to get there?

Daniel C. Ustian

Yes but, we keep making strides on getting there quicker so we may get there on some products even earlier than that. But, 2012, 2013 is probably where we’ll have all the products ready. But, like I said, we keep making progress on subtle things within the engine to keep moving forward on it without any major change so we could pull some of that forward possible.

Kirk Ludtke – CRT Capital Group

I have a quick question on Navistar financial, it looks like the leverage is down to about 11 times. I’m curious, I know this is also an evolving discussion as the credit markets free up but, where do you think you need to get the leverage at Navistar Financial in order to refinance those facilities?

A.J. Cederoth

Well, I think it’s certainly coming down, that’s a function at a point in the cycle. Exactly where it needs to be the industry trends are anywhere between 8 to 1 to 10 to 1 and it all depends on how you measure the portfolio or the balance sheet leverage. But, we continue to work on that to bring that leverage down so that Navistar Financial is a more attractive refinancing opportunity.

Kirk Ludtke – CRT Capital Group

Do you think you can get to whatever the range is with earnings or do you think that the parent will have to downstream some cash?

A.J. Cederoth

We’re working on all of that. I think there are a couple of different ways that we can approach that. Those are some of the things that we’re working on with our banks right now so we’ll have more information on that as those strategies develop.

Kirk Ludtke – CRT Capital Group

Switching to Blue Diamond, it looks like you accounted for it on the equity method in the first half of the year but now that you own 75% of it I guess we’ve been thinking you would consolidate it at least for the second half but there seems to be some uncertainty in the 10Q as to how you’re going to account for it so I’m just curious how did you account for it in your guidance?

A.J. Cederoth

Well, in the guidance the guidance is all about the earnings so how we account for it really won’t impact the guidance at all. Whether we fully consolidated Blue Diamond Parts and Blue Diamond Truck it comes down to some fairly technical issues around variable interest entities and effective control. We haven’t historically consolidated those issues, those two joint ventures so as we finalize the documents, the final documents will really guide the accounting there. We’re very close to having that done and we’ll have that ready for our Q3.

Daniel C. Ustian

But, it’s likely we’re going to consolidate. What is that $400 or $500 million in revenue won’t change the bottom line.

Kirk Ludtke – CRT Capital Group

No, it wouldn’t change EPS, I’m just thinking manufacturing segment profit and sales. Wouldn’t it have an impact?

A.J. Cederoth

It will impact sales but it won’t change segment profit. It’s consolidated inside of the engine segment today.

Kirk Ludtke – CRT Capital Group

It wouldn’t be in manufacturing segment profit?

A.J. Cederoth

It would be, that’s where it is today.

Kirk Ludtke – CRT Capital Group

Did you account for it on a consolidated basis in the guidance?

Daniel C. Ustian

You’re talking about a couple of hundred million is what it would be in the second half so I don’t know if it’s that precise. We did account for it in terms of the EPS but not the revenue.

Kirk Ludtke – CRT Capital Group

Then lastly, it looks like GM did not find a buyer for its medium truck business. Do you think that has any impact on your one way or another?

Daniel C. Ustian

Well it will certainly have an impact on the medium truck market what happens there and where that goes. Keeping in mind now that we get two chances to have that, number one is through the international brand and one is we now own 75% of the Ford mid range truck production as well so we’ve got two shots at it. The second part of it is in Class 4 and Class 5 obviously, we don’t have a product there so that leaves Ford with the only product out there in the market place.

Kirk Ludtke – CRT Capital Group

When do they shut down do you think?

Daniel C. Ustian

I don’t know that they’re coming back you’d have to ask them. My understanding is they may take a few more orders and that’s it.

Operator

Your next question comes from Walter Liptak – Barrington Research.

Walter Liptak – Barrington Research

I wanted to ask about working capital and you talked about that being a key driver to cash. Can you talk about the components of it specifically inventory?

A.J. Cederoth

I guess what’s your question on it?

Walter Liptak – Barrington Research

The question is if you look at the inventories, your inventories declined 7% sequentially but your truck sales were down a lot more than that and then year-over-year the inventory still look like they’re very high, they haven’t come down. Obviously the engine issue is one of them but I was wondering if you can talk about where is the inventory building up, is there a used truck inventory issue?

A.J. Cederoth

The used truck inventory I think has come down from Q1 to Q2 by a couple of million. Inside of the operations there’s more working capital used in the military business so when you look at the overall market decline in North America, that’s offset by the use of working capital in the military. There’s a little longer order to delivery cycle there so we carry more inventory, things get held up in receivables for a little while longer. So, the military business is less efficient with working capital than the traditional markets so that builds that number up.

Walter Liptak – Barrington Research

Is there a military working capital build for MATV?

A.J. Cederoth

That’s not in our numbers right now but if we win MATV we’ll obviously need to stage some material ahead of productions both vehicles and armor.

Daniel C. Ustian

The only thing I would add to that is that we do have some. The requirements are such that if you get the bid you have to turn right around and start shipping so we’re pre building inventory.

Walter Liptak – Barrington Research

How many pre builds do you need?

Daniel C. Ustian

We don’t do any pre building, we don’t need to do any pre building, it’s one of the advantages that we have. If we have the parts we can put that together in no time and in fact we can get the parts quicker than anybody else. This is the thing that separates us from everybody else but, their requirements are such that they need some very quickly so we do have some inventory in components only ready for that.

Walter Liptak – Barrington Research

When you add capacity for MATV, how many trucks per month will you be able to produce?

Daniel C. Ustian

500 a month.

Operator

Your next question comes from Brian Sponheimer – Gabelli & Company.

Brian Sponheimer – Gabelli & Company

My question was on the GM medium truck business and maybe if we can drill down a little bit more as to what business Ford is presumably taking and where that would have affected you in years past versus obviously what you’re looking at now with Blue Diamond and where you can maybe pick up business?

Daniel C. Ustian

If the GM goes out?

Brian Sponheimer – Gabelli & Company

With the medium truck business?

Daniel C. Ustian

Well typically both Ford and GM they get in to the low end of that sector so they’ll get a lot of government bids, they’ll get the low priced vehicles and they compete and then we’re in some of that too but not as much as they are to each other. So, what will likely happen to that is pose an opportunity for us to get some of that and also for Ford. That’s just the way the mid range sector is. We have some of our customers that buy both us and GM and that’s a great opportunity for us to capture all of that business. It’s a little opportunity but until the market comes back I would say that’s not huge. The market is very slow right now in mediums, more than any other sector.

Brian Sponheimer – Gabelli & Company

What types of vehicles do you think, from customers that use to buy from both you and GM would you be able to pick up there?

Daniel C. Ustian

Well you’d take some of the utility vehicles that are out there, they use it for the utilities on the back, you take some of the local small businesses for construction, those are the areas that typically would buy a GM or a Ford and we’ll bring them up to a Class 6 vehicle. A lot of those are Class 5s.

Brian Sponheimer – Gabelli & Company

If I could just move over to Navistar Financial, what obstacles are really in the way to securitize a similar batch of receivables at this point? Or, I guess to ask it another way, what enabled you to securitize $300 million in this quarter and what has changed sense?

A.J. Cederoth

Well, there’s really been no change, we’ve been regularly securitizing our retail portfolio through bank conduits and public securitization. With the disruption in the markets we became a little more dependent on the bank conduit facilities. This last deal we did through one of our bank conduits but as we see the recovery in the public securitization markets we think that broadens the field. So, there’s fundamentally nothing wrong with Navistar Financial, their portfolio is in very good shape and they’ve got a good history of managing their retail portfolio and their wholesale portfolio. So, we’ve really been waiting for the markets to recover so that we can take advantage of that.

Operator

Your final question comes from [Chris Edwards – Jefferies].

[Chris Edwards – Jefferies]

Just one question, something in the release kind of stuck out at us and I was just wondering if you could provide some more color on the out of period accounting adjustments that you said provided a benefit in the quarter?

A.J. Cederoth

Yes, there were two major items there, I wouldn’t call them major, they added up to be material and we felt it was appropriate that we disclose those. One, was an inventory adjustment that relates to a prior period and one was the elimination of a duplicative reserve that goes back to several prior periods. We just wanted to be forth right and upfront that there were a few positive impacts from those accounting adjustments in an effort to have full disclosure.

[Chris Edwards – Jefferies]

About how much was that in total?

A.J. Cederoth

Inside the Q it’s $19 million.

Operator

With no more questions in the queue I’d like to turn the call back over to our presenters for any additional or closing remarks.

Heather Kos

Thank you for your participation today. If you have any questions please contact me, Heather Kos and Randy Diaz and we’ll get back to you promptly. Thanks.

Operator

This concludes today’s conference. We thank you for your participation.

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Source: Navistar International Corporation Q2 2009 Earnings Call Transcript
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