Federal-Mogul Corporation (FDML) CEO Discusses Q2 2013 Results - Earnings Call Transcript

Federal-Mogul Corporation (NASDAQ:FDML)

Q2 2013 Earnings Call

July 22, 2013 10:00 am ET


Steven K. Gaut - Vice President of Corporate Communications & Government Relations and Member of Strategy Board

Rainer Jueckstock - Co-Chief Executive Officer, Chief Executive Officer of Powertrain Division and Director

Kevin P. Freeland - Co-Chief Executive Officer and Chief Executive Officer of Vehicle Components Segment

Alan J. Haughie - Chief Financial Officer, Senior Vice President and Member of the Strategy Board


Bret David Jordan - BB&T Capital Markets, Research Division

Mario Joseph Gabelli - GAMCO Investors, Inc.

Brian Sponheimer - Gabelli & Company, Inc.

Patrick Archambault - Goldman Sachs Group Inc., Research Division


Good day, ladies and gentlemen, and welcome to the Second Quarter 2013 Federal-Mogul Corporation Earnings Conference Call. My name is Jackie, and I will be your coordinator. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I will now like to turn the presentation over to Steve Gaut, Head of Investor Relations. Please proceed.

Steven K. Gaut

Good morning, everyone, and thanks for joining Federal-Mogul's Second Quarter 2013 Earnings Call.

On Slide 2, you'll find the company's Safe Harbor statement. Please note that the contents of the presentation slides and the comments and discussion provided by our speakers today are covered by the provisions of this statement.

On Slide 3, we have the agenda. Our speakers today will provide an update on our second quarter results and also cover some important recent developments in the company.

Rainer Jueckstock will provide a brief total company results overview, then he and Kevin Freeland will discuss the markets and current developments relating to their respective business segments. These comments will be followed by Alan Haughie with additional details on second quarter financial results. And then after the comments, we'll come back to a Q&A.


Rainer Jueckstock

Thanks, Steve, and good morning to everyone. I would like to briefly cover Slide 4 in the event that there are members of today's audience that are not familiar with Federal-Mogul.

The company had total sales of about $6.5 billion in 2012, with balanced revenues across geographic markets. We have an extensive footprint that enables the company to serve customers in every region from, both the manufacturing and distribution perspective.

Our customer base includes light-, medium- and heavy-duty vehicle manufacturers, industrial engine equipment makers and the global automotive aftermarket. This global customer is reach -- is built on a solid foundation of decade-long customer relationships and a strong presence on our lead customer Powertrain and Vehicle platforms and through our premium trends and an extensive aftermarket distribution network. We are very focused on maintaining a highly competitive pipeline of technologies that meet customer needs and enables them to meet regulatory and market requirements. Finally, since September 2012, the company has been operating under 2 independent operating segments that each have customer-focused business models, enabling business decisions that are optimized to meet the needs of the respective segments.

Please turn to Slide 5. Federal-Mogul had good performance in quarter 2 2013, with sales and EBITDA solidly in the upper part of our guidance range. As a reminder, as part of the process for the shareholder rights offering, we provided quarter 2 sales guidance of $1.7 billion to $1.8 billion and EBITDA of $150 million to $165 million. Today, we are reporting sales of $1.8 billion and EBITDA of $163 million.

I want to use this opportunity to confirm our previous full year guidance for sales of $6.8 billion to $7 billion and EBITDA of $560 million to $650 million. Of course, these projections are subject to our previously communicated assumptions, including total revenue, unforeseen global financial market or industry conditions or other factors that might limit our ability to restructure our operations or otherwise achieve our plans.

Our quarter 2 net income is $56 million, which is up from a loss of $59 million or very comparable to a more realistic comparative 2012 net income of $60 million when excluding $119 million impairment recorded in quarter 2 2012. Another very important accomplishment is free cash flow of $73 million in quarter 2. Since this is a growth of -- from prior quarters of cash outflow separated to its operational weakness or the expansion of long-dated accounts receivable terms, which we have discussed in previous quarters, we also have proceeds of $15 million in the quarter from a small divestiture, in addition to the $73 million of cash generated by the operations.

We also made good progress on our restructuring actions and ongoing cost reductions during quarter 2, including announcement of additional plant closings, the sale of 2 small somewhat niche business lines located in high-cost countries and continued streamlining related to our overall organization. I believe our teams did a good job of executing in quarter 2, but we are also helped by a more stable order flow across our global operations, the sales rates above the underlying production flow rates, demonstrating market share gains.

Please turn to Page 6. I anticipate that there will be questions today about the status of our refinancing activities. Also, since we wait until our Q&A, I will cover the following points. As you may know, Federal-Mogul, on July 9, completed the stockholder rights offering that was fully subscribed at the level of $500 million. The proceeds were received on July 12, and we want to thank all participant -- participating shareholders, especially our majority shareholder, Icahn Enterprises, for their show of support and confidence in Federal-Mogul.

The deleveraging impact on the balance sheet brought about by the rights issue was very positively received by many of our key customers. We believe that the rights offering proceeds, along with our positive cash flow and thus, equivalent form of liquidity, placed Federal-Mogul in excellent position to invest in the business and provides flexibility to choose appropriate time to refinance our debt.

Please turn to Page 7. One of the important factors in the company's strong earning recovery from second half of 2012 is restructuring and divestiture activity. The restructuring has included the announced closure of 8 sites listed in the slide, some of which are still in the process to be finally closed.

While these are always difficult decisions, these actions have already allowed us to move some customer programs towards existing Federal-Mogul locations, especially in lower-cost locations in Mexico or Eastern Europe, while continuing to serve our customers in other countries. We have also completed the divestiture of business that involves the elimination of loss-making or low-margin, noncore business. These units will have the chance to attract capital from the autonomous that views business as core. By selling these locations, Federal-Mogul can focus to improve our core business lines and allow better allocations of capital investments to maintain and grow in the right places.

Overall in the first half of 2013, the company has exited finally 8 manufacturing plants in high-cost countries while either disclosure or divestiture. We have also continued our ongoing streamlining to reduce support and SG&A costs, and we continue to execute all other restructuring and downsizing actions that cannot yet be disclosed because we are in the process of discussion with employee representatives.

Please look at Slide 8. I'm not going to cover all of these points in the slide. However, they do illustrate the difference between the business models between Powertrain and Vehicle Components segments. We will now focus the presentation of -- on the 2 business segments and our second quarter accomplishments.

Please turn to Page 9. The Powertrain segment had revenue of $1.1 billion in quarter 2, up $68 million or 7% from quarter 2 2012. This revenue increase was driven by 6% higher revenue in North America, while the North American light vehicle market just grew 5%, and simultaneously, the commercial vehicle market in the region declined 9% versus quarter 2 2012. So clearly, we gained some traction in the market has more than offset the -- in commercial vehicle demand and had an overall total revenue increase. The story in Europe is, again, about offsetting market decline. Powertrain in Europe, which represents approximately 50% of total revenue, had slightly revenue growth in quarter 2. However, both in -- both light and commercial vehicle production went down 3% in light vehicle and 8% in heavy duty. Keep in mind, car sales in Europe in February, March, April, May each held to a record 20-year monthly low. Further, heavy duty globally in the first quarter -- in the first half was significantly below record high levels of 2008, and the market is still below 2011 and 2012 production numbers.

The Powertrain segment had EBITDA of $106 million in quarter 2 2013, slightly up from last year in quarter 2, and we are pleased to see several signs of market stabilization throughout the global markets. Even so, we still have some mix impact in Europe that [indiscernible] from our earnings.

We see our achievement in quarter 2, which by the way was still a difficult market environment, has a nice building block on the foundation we established in quarter 1 2013. However, we have still more opportunities we need for restructuring on the horizon in order to further improve our margin performance.

Today, we are more optimistic about our operational performance, losses in accounting on performance due to the market recovery. We have solid operational and efficiency and performance improvements coming. And to start the production of -- for profitable new business, contracts it -- will drive our performance and this will put us in an excellent position for volume-based operational level entrance markets into a [indiscernible].

Please turn to Slide 10. Before I turn the call to Kevin Freeland, I want to make a moment to highlight some of the main market and near-term outlook. The U.S. continues to get strong in the LV market and has modest growth forecast in 2018. We see additional growth coming from current Powertrain trends who are downsizing and downspeeding since we often added more feature content to withstand the stress of these hotter-running, highly loaded engines.

We don't see an immediate turnaround for the commercial and heavy duty markets, but we will be ready to leverage the eventual recovery in future quarters. Europe remains concerning as the market growth is soft in the next few years. We have similar demand for added technologies from our core Powertrain product line and are hopeful the slight improvement in diesel penetration in quarter 2 2013 is the beginning of the shift back to higher demand for more profitable diesel components.

China remains a bright spot, with vehicle production growing up to -- with 31 million units per year and a compounded annual growth rates of 9% through 2018.

India is concerning for its weakness this year, and we are refocusing our attention on the present use of our existing footprints as we watch carefully to see what this market is going to do over the coming quarters.

Finally, Brazil is expected to show growth also from low basis. We continue to focus also there on asset utilization and increasing penetration on global platforms.

I'm now pleased to introduce Kevin Freeland, who joined Federal-Mogul just a few weeks ago. He will give you some background information about his career and their VCS business in quarter 2.


Kevin P. Freeland

Thanks, Rainer. As Rainer mentioned, I joined Federal-Mogul last month as the CEO of the Vehicle Components Segment, and I'm proud to be leading a talented VCS team. I was previously the Chief Operating Officer for Advance Auto Parts, one of VCS's top customers. Prior to that, I ran a consulting firm helping manufacturers and their distributors collaborate more efficiently. Prior to that, I worked at Best Buy ultimately as President of their second largest division. I'd ask you to please turn to Slide 12.

For the quarter, revenue for the VCS segment was $783 million, up 5% on a constant dollar basis compared to Q2 2012. The improvement was primarily due to a strong European aftermarket sales trend. Overall, sales in North America were down 1% as we exited some unprofitable contracts. The U.S. aftermarket sales were up slightly versus Q2 2012.

Europe, Middle East and Africa was a strong market for us in the second quarter of 2013, with total revenue up 20%, a 10% growth in the base business, excluding the BERU aftermarket ignition distribution agreement that we entered into in Q1 of 2013.

EBITDA was $57 million, up $2 million from last year. On a sequential basis, our EBITDA continued to grow, and we're seeing the benefits of our restructuring actions and the end of certain underperforming contracts.

We're on schedule with our previously announced site closures, and we're continuing to assess and rationalize the footprint of the vehicle component facilities, so that we're optimally utilizing our capacity and achieving savings in our manufacturing costs.

As a team, we're continuing to focus on the fundamentals, including managing our working capital, ensuring we're well positioned to fill customer orders and deploying new strategies to grow the equity of our brands.

Slide 13 highlights some of the key accomplishments within the Vehicle Components segment during the quarter. Braking, which is the largest product line within our segment, successfully won several conquest-breaking contracts for global OE programs. With regard to our aftermarket portfolio, we're continuing to develop new commercial strategies to differentiate our brands in the marketplace. We've recently announced the unique partnership with the National Hockey League. Our ANCO wipers are now the official wiper blade of the NHL. This exclusive marketing partnership is an ideal fit for the ANCO brand and aligns our North American wiper line with one of the largest and most passionate band bases in professional sports.

Our order flow was extremely strong compared to last year, which is critical for keeping satisfied customers. A key European aftermarket customer expressed their satisfaction recently by presenting us with the Supplier of the Year Award, which we deeply appreciate. The strategic locations of our distribution centers are important to develop to delivering high fill rates. And during the quarter, we opened a new distribution center in Istanbul, Turkey.

We've discussed the restructuring and manufacturing rationalization that's been occurring over the past 18 months, and we're continuing to look at opportunities to reduce our structural costs, improve our manufacturing and distribution footprint and increase the capacity utilization of our plants.

At this time, I'll turn the call over to our CFO, Alan Haughie.

Alan J. Haughie

Thanks, Kevin. Now please turn to Slide 15 for more details of our second quarter earnings performance.

Our results are presented here on a continuing operations basis. During the quarter, we divested our noncore camshaft and con rod businesses. These transactions resulted in cash proceeds of $15 million and a book loss of about $6 million for the quarter. These businesses in 2012 generated sales of $42 million and EBITDA of roughly $1 million. The recognition of the loss on divestiture combined with the operating results of those businesses for the quarter is shown as a 1 line entry under loss and discontinued operations of $6 million. So on a continuing operations basis, the company reported sales of $1.8 billion, net income of $64 million and EBITDA of $163 million.

Now with respect to the main drivers of performance. Sales increased by $97 million, including just $8 million of positive currency impacts, so the constant dollar sales increase is $89 million. And if we strip out the impact of the BERU spark plug acquisition and a further $27 million due to the European aftermarket distribution agreement for ignition products, then we are left with $46 million of organic sales growth, $41 million of which was in the Powertrain segment, representing growth of about 5%, and the remainder of $5 million in the VCS.

I will discuss the OE market movement in more detail shortly. But in general, with light vehicle production in Europe remaining below last year's levels and the same being true for commercial vehicle production in both Europe and the U.S., an increasing Powertrain sales of 5% represents growth over and above the OE vehicle production market.

Gross margin increased by $23 million and 0.5 point. Although we have experienced stronger sales growth versus the market, our margins are still suffering from the fact that commercial vehicle production has fallen to a larger extent than light vehicle production has. And even within light vehicle production, the proportion of diesel applications is lower than recently expected long-term level.

However, this mix impact has been partly offset by our cost reduction actions, combined with savings in material costs. As a result, our second quarter gross margin of 15.8% is better than both the first quarter of this year as well as the third and fourth quarters of 2012.

SG&A has increased year-over-year by $12 million, including $5 million as a result of the BERU acquisition and aftermarket distribution agreement, combined with increased incentive compensation compared to last year. But against this backdrop, we have made significant progress in sustainable SG&A cost reductions in the quarter.

Interest expense is low in the prior year due to the roll-off about midway through the first quarter of our out-of-the-money interest rate swaps established in 2008, which will cost the company about $40 million a year or roughly $9 million a quarter. The impairment charge in the second quarter of last year mainly related to our braking product line intangible assets. And this year, we recorded an OPEB curtailment gain as a result of the closure of one of our U.S. brake facilities.

The tax charge of $13 million contains no unusual items, but last year's income tax benefit of $29 million included a number of items: a U.S. reserve release of $19 million; a valuation allowance released in Germany of $11 million; a Polish investment credit of $5 million; and a $7 million benefit due to the impacts of the impairment.

And so our net income from continuing operations is $64 million versus a net loss of $54 million last year, and we report a net income attributable to Federal-Mogul including the loss of discontinued operations of $56 million versus a net loss of $59 million last year.

On Slide 16, we have a reconciliation of our EBITDA for the periods to our net income from continuing operations. And included above is also, a breakup of our EBITDA by segment, which will be covered in more detail in a few moments.

The impairment charges in OPEB curtailment gains are of course excluded from EBITDA. And the other only item worthy of note is the impact of freezing the U.S. funded pension plan in 2012 as a result of which the nonservice cost proportion of the expense is negligible for 2013, hence the reduction in the charge of $9 million per quarter in 2012 to $1 million per quarter this year.

Turning now to Slide 17, which describes the second quarter performance of the Powertrain segment. Sales increased by $68 million or 7%. On a constant dollar basis, the sales increase was 6%. And furthermore, when we strip out the year-over-year impact of the BERU spark plug acquisition of $16 million, the organic year-over-year sales increase was $45 million or 5%, which comprises $41 million of external sales growth and about $4 million of increased intersegment supply to VCS.

By major region, North America grew by 6% or $20 million. The rest of the world grew by 13% or $20 million. And Europe increased by 1% or $5 million. And this improvement in the European sales should be measured against reductions in European light and commercial vehicle production of 3% and 8%, respectively, and so demonstrates solid growth in market share.

Our operational and overhead cost control actions are starting to take effect in spite of the European volume and mix headwinds. And as shown on the bottom left of the slide, our EBITDA as a percentage of revenue and in absolute dollar terms continues to increase quarter-over-quarter.

Turning now to Slide 18, which describes the second quarter performance of the VCS segment. Revenue increased by $34 million or 5% year-over-year with negligible currency movements. Furthermore, I've mentioned we entered a European aftermarket distribution agreement for ignition products during the first quarter of the year, and this added about $27 million to European revenues. Stripping out these factors, [indiscernible] VCS with an organic revenue increase of about $7 million or 1%. This does reflect the 1% decline in North America, largely as a result of managed exits from some low margin OE business. The U.S. aftermarket itself grew by 1%, and the European aftermarket, as Kevin mentioned, by 10%.

EBITDA was $57 million, compared to $55 million in 2012. And as shown in the chart on the bottom left-hand side, VCS, is experiencing a similar trend with the Powertrain segment, with EBITDA increasing both in absolute dollar terms and as a percent of revenues since the third quarter of 2012.

On Slide 19, we have a summary of the second quarter consolidated cash flow. We generated $166 million of cash from operating activities, compared to an outflow of $12 million last year, an improvement of $178 million. And this was principally due to more stable working capital, with an inflow of $8 million this year, compared to an outflow of $138 million last year, an improvement of $146 million. And this working capital improvement is achieved through the results of the extended terms to aftermarket customers reaching its plateau as predicted in prior quarters. Furthermore, pension and interest payments were lower by $7 million and $9 million, respectively, with the latter being absorbed of the interest rate swaps in China.

We hold capital spending to similar levels of last year, $92 million in both this year and last year, and generated $15 million in proceeds from the divestitures of further noncore businesses. So as a result, our free cash flow, being cash from operating activities less capital expenditures for the quarter, is an inflow of $73 million, compared to an outflow of $105 million over the same period last year.

Please turn to Slide 20 for more details of the first half earnings performance. The year-over-year sales increase of $53 million contains virtually no currency impacts. And when we exclude the impact of the acquisitions of about $30 million and the European aftermarket distribution agreement of $55 million, we have about $30 million of organic constant dollar sales decline. And this sales decline comprises roughly $10 million of increased sales in Powertrain offset by a decline of $14 million in VCS.

Now given Powertrain's relative presence in the light vehicle, commercial vehicle and industrial markets and the relative year-over-year change in the production rate in those markets, Powertrain's underlying market demand arguably fell by about 3% for the half year, driven by about a 7% decline in European light vehicle production, a 10% decline in European commercial vehicle production, 15% decline in North American commercial vehicle production, partly offset by 3% increase in North American light vehicle production. But against this underlying 3% backdrop, our sales was slightly positive, again, indicating solid market share gains over and above the market. For VCS, the sales decline reflects the managed exits in certain unprofitable product lines, some softness in the export market, particularly in Venezuela in the first quarter, partly offset by increased sales in Europe of about 4%, somewhat countercyclical to the European OE market.

The $2 million drop in year-to-date gross margin is largely due to the mix issues discussed earlier, partly offset by our operation improvements in material cost savings largely in the second quarter. The majority of the remaining profit and loss items are the second quarter ones mentioned earlier, except for the loss in discontinued operations, which include the first quarter divestiture of the Sintertech business in France. As a result, for the half year, we report income from continuing operations of $85 million, compared to a loss of $17 million last year, a net income attributable to Federal-Mogul of $22 million, compared to a loss of $26 million last year. EBITDA was $304 million for the half year, $17 million lower than last year, but reflects healthy progress towards the full year EBITDA guidance of $560 million to $615 million that Rainer mentioned earlier.

On Slide 21, we have a reconciliation of our net income for the period to our profit measure, operational EBITDA, and the structure of this reconciliation is identical to that just described for the second quarter, so I will not dwell on it.

And finally, on Slide 22, we provide a summary of the year-to-date consolidated cash flow. We generated $116 million of cash from operating activities compared to an outflow of $7 million last year, an improvement of $123 million. And again, this was principally due to more stable working capital in the second quarter, with an outflow of $97 million for this half year compared to an outflow of $215 million last year, a year-over-year improvement of $118 million. And furthermore, the interest payments were lower by $11 million as the result of the interest rate swaps maturing again.

The slightly lower capital spending pattern for the half year has been offset somewhat by the net payments for divestitures, resulting in $11 million increase in investing activities. As a result, free cash flow for the half year is an outflow of $70 million compared to an outflow of $230 million over the same period last year. And this leaves us with healthy liquidity comprising $375 million of cash, $450 million in undrawn revolver, significant receivables available for factoring but untapped and of course, as of July 12, a further $500 million from the recent concluded rights offering.

Now I will hand back to Rainer for closing comments.

Rainer Jueckstock

Okay. Thanks, Alan. And while he was speaking, I had a couple for my call, so I ask you now to turn with me to Slide 23. Before the Q&A, I would like to finalize our comments by highlighting the most important opportunities for margin improvement directly in front of Federal-Mogul in the near terms.

First, we have solid market growth in both the OE and the aftermarket business throughout the group. The period between 2013 and '18 provides excellent opportunities to take advantage of growth in new vehicle production and global car parc expansion. That market share growth can continue for Federal-Mogul on the basis of our technologies to enable fuel economy, reduce emissions and provide superior vehicle performance with sensitivity to environmental impact.

Vehicle makers are willing to pay a premium for breakthrough products that enable them to meet these key challenges, and this provides excellent drive for collaborative R&D in both segments. As Kevin outlined, our VCS business in the specialties aftermarket has important trend differentiation to drive customer loyalty and therefore opportunities to enhance the way we approach the market to unlock greater value in Federal-Mogul products and services.

Finally, we have already today outlined the significant restructuring opportunities already underway and yet to come that should provide great operating leverage as market return to healthier levels.

Now let's take your questions. Operator, please give the Q&A instructions.

Question-and-Answer Session


[Operator Instructions] Your first question comes from the line of Bret Jordan with BB&T Capital.

Bret David Jordan - BB&T Capital Markets, Research Division

This question's probably for Kevin. It relates to North American aftermarket. I think you said your aftermarket growth x the divestitures was 1% in the period. And I guess, how would you compare that to the industry growth in those categories? And maybe if you could give us any color on outliers, either areas of particular strength or weakness in North American aftermarket and product categories.

Kevin P. Freeland

Yes, the market -- North American aftermarket has had some competitive ups and downs this year. There's been a lot written about the weather impacts both first quarter and second quarter in different parts, both conducive weather in the Southwest and out West and tougher conditions on the East Coast and the South. So varying customers of ours have had some pretty stark differences in terms of their -- the orders that they've placed with us. Generally, as you look across our businesses in the ceiling areas and in the chassis areas, we've had relatively good business through the first half of the year. And generally, our -- the thing that has our attention these days is the friction business, which, in the aftermarket, has held up fairly well and has been the area that we've struggled with the most.

Bret David Jordan - BB&T Capital Markets, Research Division

Okay. And I guess, as you look at that 1%, is that -- did you gain share in North America? Or do you think the industry in the categories you're competing in, did that -- was industry growth about 1% or plus or minus 1%?

Kevin P. Freeland

I don't have the exact numbers, but we held up fairly well against the market. But I do believe we gave back some more friction.

Bret David Jordan - BB&T Capital Markets, Research Division

Okay. And then I guess one last question as you look at the distribution channel having recently come from the other side of the business. I guess, as you look forward with Federal-Mogul and the factoring programs, do you think that -- this is sort of an industry question. Do you think the ability to extend terms is reaching a limit now that you're on the other side of the table? Or do you see the retailers continuing to be able to drive north of 100% A/P'd inventory?

Kevin P. Freeland

I think the comment that was made earlier, as it relates to our company, that the worst of that transition appears to have occurred. Certainly, the dialogue that I'm having with the customers there, it has predated me in terms of its impact on the company. I think we're probably at a point that's relatively steady-state from this point forward.


Your next question comes from the line of Mario Gabelli with GAMCO Investors.

Mario Joseph Gabelli - GAMCO Investors, Inc.

Kevin, welcome aboard. And, Alan, here's a question for you. It's not complicated. Can you walk me through the pension costs, the NOL and the dynamics that were announced in your rights offering? Because I'm still trying to figure out what the DOL and PBGC and all of those entities look on when you do a transaction like this.

Alan J. Haughie

Not complicated, all right.

Mario Joseph Gabelli - GAMCO Investors, Inc.

Come on, Alan, you're the best at simplifying things. This is the Gordian knot that's easy, except for me as an analyst.

Alan J. Haughie

Yes, well we have -- at the moment, when you look at the accounting basis form from the pension liability, which is actually the most accurate way of looking at it, we ended the year about $500 million underfunded. We'll be in a better shape than that now given reasonably good investment performance for the half year. So let me tell you that...

Mario Joseph Gabelli - GAMCO Investors, Inc.

Alan, I'll just admit on that one, I don't have your 10-K in front of me. What was your discount rate at that time? Well, that's -- I'll get it from you offline. Go ahead.

Alan J. Haughie

I think about 4.5%, from memory.

Mario Joseph Gabelli - GAMCO Investors, Inc.

All right. So then take us from there.

Alan J. Haughie

Yes. So we've got essentially $700 million of assets under $1.2 billion present value liability, and that's essentially where the $500 million unfunded position comes from. At the moment, the pension scheme is frozen, so there is no longer any service cost element. So no one in the scheme is generating further benefit. Prior to freezing the scheme, the expense was running at about $55 million a year, comprising $20 million of service cost and $35 million of other costs, which are essentially the amortization of the historic and current pension performance. So our expense has now fallen because the $20 million of service cost has gone away. The $35 million of other costs have also fallen away at the moment. And that's because when you freeze a pension scheme, under various circumstances, the amortization rate applied to the remaining liability gets spread over the remaining lifespan of the individuals as opposed to their remaining working life, and that produces a much longer amortization period. And that's why the expense has basically fallen away because of that longer amortization period because the scheme is now frozen. From a -- on a reserve basis, the calculation's very different. It has a -- the MAP-21 Rules that mean that we can use a much higher discount rate. And therefore, the rate at which money has to be put into the scheme is significantly lower. Therefore, the unfunded position from the risk perspective is much lower than the book value of the accounting basis but in terms of looking at the liability on the accounting basis, actually gives a closer representation to the true value of that liability. The -- sorry.

Mario Joseph Gabelli - GAMCO Investors, Inc.

Okay. Alan, that gave us a snapshot, a good 101 outstanding dynamics, but tell us how the tradeoff between the NOL at Coliton [ph] and the pension dynamics, how -- what...

Alan J. Haughie

I see what you mean. Here's what happens. When Federal-Mogul was taken -- now that we're [indiscernible] more than 80% of Federal-Mogul, there is an obligation for us to join the tax group. And Federal-Mogul today has about $1.3 billion of U.S. NOLs that are fully reserved against in the balance sheet because there is no, currently, prospect of us being able to utilize them against huge profits. Those NOLs now become part of our ownership structure's tax group, and that's mandatory given the ownership change. On the flip side, our pension liabilities are also part of, essentially, the control group, too. So there is a -- there's a path, like you said -- obviously, you're probably trying to get me to say this, a counterweight to the NOLs being part of that control group. There are all the pension liabilities of Federal-Mogul also become essentially part of that control group, too.

Mario Joseph Gabelli - GAMCO Investors, Inc.

Well, and the economics -- doesn't the pension cost remain a joint and several liability of the -- of both entities so that if, for example, Icahn goes bust, God forbid, you're still liable for the pension plans? Don't tell Carl I said that, please.

Alan J. Haughie

Hey, he might be listening.

Mario Joseph Gabelli - GAMCO Investors, Inc.

Yes, right. And God is always listening.

Alan J. Haughie

The question, you're quite right. You're quite right, Mario.

Mario Joseph Gabelli - GAMCO Investors, Inc.

All right. Alan, and this is just a nit because I'm trying to figure out what price certain dynamics unfold. And, Kevin, I look forward to saying hello and -- in person and whether in Las Vegas or at our conference or some other trade group meeting.


Your next question comes from the line of Brian Sponheimer with Gabelli & Company.

Brian Sponheimer - Gabelli & Company, Inc.

Welcome, Kevin. Well, I'll talk about the business here a little bit. Alan, on the guidance for the year, $560 million to $615 million in EBITDA, you're at $304 million right now. That implies under almost best-case scenario that you're only matching the first half of the year from a profitability standpoint. Obviously, understanding that the third quarter is weak on the OE side from seasonal shutdowns, why shouldn't we consider that guidance is relatively conservative given a better commercial vehicle outlook and the obvious sequential improvements that you guys are making on your own profitability?

Rainer Jueckstock

Okay, Rainer speaking. Even you directed this question to Alan, he asked me to answer. I think you use part 3 to answer already. Quarter 3 for automotive is a weak quarter. The customers in Europe and partly in the U.S. are on vacation. We've seen most of our customer shutdowns for 1 week, 2 weeks. But we have to be fair. In the U.S., the shutdowns got reduced. On the other hand, some of our European OEMs increased their shutdowns. What is also important to note that December is normally the lightest month for OE business. Therefore, in the history of Federal-Mogul Powertrain, we had 52%, 53% of sales and earnings in quarter 1 and 2 and then the remaining 47%, 48% in the second half of the year. So that's the reason why we came with the numbers Alan mentioned.

Brian Sponheimer - Gabelli & Company, Inc.

Okay, great. And then I guess, onto Kevin, I know you've only been on the job for a few weeks here. But given your industry experience, particularly around brand building, where do you think the biggest obstacles are in reestablishing some of these fantastic brands that you now have under your control that have been diluted somewhat over the course of the last few years?

Kevin P. Freeland

Well, I'd say that the -- there's a good side to that, and that you look kind of the dark side, that you painted it. The brands actually have high levels of awareness. They have very positive imagery with the installer base. It is a relatively small population that we're trying to talk to in North America. 80,000 garages account for the lion's share of all the repair work done in North America. It's just that the difficult group to reach, many of the traditional ways to communicate with them are essentially don't -- just don't translate into that channel. But as you mentioned, I had just come off a stint of spending 5 years trying to talk to them. The company I came from went from, I guess, 15% of their business sold into the installers to 40% this year, and many of the methods that were used apply both to -- to both distribution and manufacturer. But it will be an area of focus, and I believe it's an opportunity for us, not a concern.

Brian Sponheimer - Gabelli & Company, Inc.

All right. And, Alan, just one last one if you don't mind. From a CapEx perspective, it was a pretty big tick down in what your outflow was this quarter, and it's away from trend. What do you think -- did -- have you discovered pockets for savings on the CapEx side, do you think? Or should we think of this as a one-off quarter?

Alan J. Haughie

I think it's -- I think that what you're looking at is a reasonable run rate.

Brian Sponheimer - Gabelli & Company, Inc.

So that, going forward, implies $250 million a year in CapEx relative to the $370-ish million where you are running. Is that fair?

Alan J. Haughie

No, I don't -- where did the $250 million number come from? I'm not quite sure if you listened to that, but...

Brian Sponheimer - Gabelli & Company, Inc.

I'm looking at just the quarterly outflow for this quarter of $280 million on a run rate basis, $70 million this quarter.

Alan J. Haughie

Oh, you said CapEx. That's free cash flow of $70 million out, CapEx for the manufacture.


Your next question comes from the line of Patrick Archambault with Goldman Sachs.

Patrick Archambault - Goldman Sachs Group Inc., Research Division

A couple -- just a couple of quick ones. Building on Brian's question regarding the guidance. If you do look at it, year-on-year, it does look like -- at least on my math, correct me if I'm wrong, incremental margins improved. They go from, I guess, you're sort of around 9%, and then you're sort of in the 30s in the back half on my math. Can you just remind us of -- I mean, you've got aligned a lot of items. You guys have a lot going on. Can you kind of just in order of magnitude sort of give us a list of sort of what the biggest levers are? I know you have cost performance in restructuring volume, but it sounded like even though mix is trending better than you thought, it's still kind of negative. So maybe you could help us understand those factors a little better.

Rainer Jueckstock

Okay, Patrick. Rainer speaking. I'll start with some comments about the Powertrain business. The biggest thing that impacted currently feel, compared to 2012 first half year, is the change in mix both on a geographic as well as on content point. We have a low sales in Europe, number one, higher sales in the U.S. The European business, heavily driven by diesel, has a tendency to be more profitable than the U.S. business, but just mostly gasoline. And in all regions, our industrial and heavy duty business is below 2012 first half year run rate. So what we have is we replaced diesel. The market replaced to a certain extent volumes in diesel and heavy duty, and we replaced this significant inflow in gasoline business in the U.S., in China but also in Europe. So I think that is the biggest thing that impact on our margins. If you see significant sales increase of 5% for Powertrain year-over-year, but the incremental EBITDA return out of this is relatively small. That's the main reason. On top of this, these restructuring activities have the tendency to cost money and to cause attention, and we have quite a bit of this. So in the long run, I have no doubt the diesel business in Europe and the heavy duty business in the global basis as well as industrial business will come back maybe not very fast to the record level we saw in 2008. But even if it would be 2011 or 2012 first half year run rate, we would see a benefit in our margin profile. Maybe, Kevin, something from your side?

Kevin P. Freeland

Yes, the only thing I would say is that as you can see, the business is tracking relatively -- year-to-date, tracking relatively consistent with the prior year with the slight uptick in both sales and margins. And our budget for the back half of the year takes that into account. The only real anomaly that we see is the picking up of the BERU business, which is bringing on, quite frankly, more volume to us than we're currently able to drop to the bottom line. And then there's activities that we have underway. There is some redundancies between our activities in Europe and what we have acquired that, as each quarter goes by, allows us to track more value from that.

Patrick Archambault - Goldman Sachs Group Inc., Research Division

Okay. But I guess, just tying it all altogether, it sounds like despite some of the sequential issues from a mix and management use of time, you still see year-on-year incrementals accelerating, right? When you're comp-ing to the back half of 2012, which was obviously admittedly a fairly weak set of results.

Rainer Jueckstock

We are positive about the way forward. Still, if you look into Europe, you are getting very mixed messages. Some of our peers in their earning calls painted quite a critical picture about Europe in the second half. On the other hand, you might have seen Ford's announcement just a few days ago, which was quite positive. Our board thinks that the bottom is reached in Europe, and going forward, there might be more upside than downside. We have probably more depiction like Ford has.

Patrick Archambault - Goldman Sachs Group Inc., Research Division

Interesting. Okay, that's helpful color. Last one for me. I have to ask it. With the rights offering now completed, what can you tell us about next steps to address the capital structure?

Rainer Jueckstock


Alan J. Haughie

You know as well as I do that we're keeping a very close eye on the market. And same answer as before, Patrick, we are constantly reassessing the right time to reenter the market and address our refinancing. That's all I can say at the moment.

Rainer Jueckstock

Big important subject for the management in the second half of the year, but we can't tell more at the current time.


At this time, we have no further questions. I will now like to turn the call over to Mr. Steve Gaut.

Steven K. Gaut

Okay, thanks very much. And I will just close the call by saying that we appreciate your participation and look forward to your interest in Federal-Mogul when we report the third quarter later in the year. Thank you, and that concludes the call.


Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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