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Meritor (NYSE:MTOR)

Q4 2013 Earnings Call

November 13, 2013 9:00 am ET

Executives

Carl Anderson - Vice President and Treasurer

Ivor J. Evans - Executive Chairman, Chief Executive Officer, President, Member of Audit Committee and Member of Corporate Governance & Nominating Committee

Kevin Nowlan - Chief Financial Officer and Senior Vice President

Jeffrey A. Craig - Senior Vice President and President of Commercial Truck & Industrial Segment

Pedro N. Ferro - Senior Vice President and President of Aftermarket & Trailer Segment

Analysts

Itay Michaeli - Citigroup Inc, Research Division

Colin Langan - UBS Investment Bank, Research Division

Robert A. Kosowsky - Sidoti & Company, LLC

Ryan J. Brinkman - JP Morgan Chase & Co, Research Division

Douglas Karson - BofA Merrill Lynch, Research Division

Kirk Ludtke - CRT Capital Group LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Meritor Fourth Quarter Fiscal Year 2013 Earnings Conference Call. My name is Kathryn, and I will be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would like to turn the call over to Mr. Carl Anderson, Vice President and Treasurer. Please proceed, sir.

Carl Anderson

Thank you, Kathryn. Good morning, everyone, and welcome to Meritor's Fourth Quarter and Full Fiscal Year 2013 Earnings Call. On the call today, we have Ike Evans, Meritor's Chairman and Chief Executive Officer and President; and Kevin Nowlan, Senior Vice President and Chief Financial Officer. Also in the room today are Jay Craig, Senior Vice President and President of Meritor's Commercial Truck and Industrial Business; and Pedro Ferro, Senior Vice President and President, Aftermarket & Trailer. Both will be available at the conclusion of our remarks for any specific questions about their respective businesses.

The slides accompanying today's call are available at meritor.com. We'll refer to the slides in our discussion this morning. The content of this conference call, which we're recording, is the property of Meritor, Inc. It's protected by U.S. and international copyright law and may not be rebroadcast without the expressed written consent of Meritor. We consider your continued participation to be your consent to our recording.

Our discussion may contain forward-looking statements as defined in the Private Securities Ligation Reform Act of 1995. Let me now refer you to Slide 2 for a more complete disclosure of the risks that could affect our results. To the extent we refer to any non-GAAP measures in our call, you'll find the reconciliation to GAAP in the slides on our website. Now I'll turn the call over to Ike.

Ivor J. Evans

Thank you, Carl, and good morning. Let's turn to Slide 3. On the left side of the chart are highlights from our fourth quarter. As you know, Meritor's Board of Directors appointed me Chairman, CEO and President in August, after serving as the Executive Chairman, Interim Chief Executive Officer and President since May.

In addition, 2 new board members were elected in fiscal 2013. Tom Pajonas is Senior Vice President and Chief Operating Officer of Flowserve. He has extensive operational experience, as well as a strong manufacturing and engineering background. Bill Lyons, former Chief Financial Officer at CONSOL Energy, has also joined Meritor's board. Bill not only has considerable financial experience, but also serves as a trustee of a major trust fund, which contributes to the board's insights from an investor perspective.

Our margin performance this quarter was 7.7% on $909 million in revenue. Despite revenue headwinds in the period, we delivered strong operational performance. The actions we're taking to expand our margins are starting to take hold.

We also took steps to improve our balance sheet by deploying $100 million of cash to retire debt and debt-like obligations. If we look back at the past year, you can see we've taken significant steps to better position the company for growth and improve financial performance.

In May, we launched M2016, which represents our commitment to achieve a 10% EBITDA margin, $400 million in debt reduction and an incremental $500 million of new business awards in fiscal year 2016.

Our EBITDA margin for the year was 7.1% on $3.7 billion of revenue, down due to lower volumes in all markets. Despite the fact the revenue for the year was down more than $700 million, we were able to limit downside conversion to approximately 12%.

We were able to do this through solid operating and material performance, combined with restructuring actions announced earlier in the year that reduced SG&A and other fixed costs.

Overall, we are pleased with our margin performance for fiscal 2013 in spite of lower revenue levels. We expect the actions taken in 2013 will drive continued margin expansion in fiscal year 2014, even though we do not anticipate revenue growth.

Let's turn to Slide 4 for a look at our performance quarter-over-quarter. Revenue in the fourth quarter of fiscal year 2013 was $909 million, a decrease of $84 million from the third quarter, driven primarily by North American truck, typical seasonality in Europe, softening in India and the next production step-down in defense. Adjusted EBITDA was $70 million in the fourth quarter, down $17 million from the prior period, driven primarily by lower sales. Adjusted EBITDA was 7.7% for the quarter, as I mentioned earlier.

In the fourth quarter, we made a $54 million voluntary pension contribution, as well as a $33 million income tax payment associated with the gain on the sale of our ownership interest in Suspensys. As a result, free cash flow from continuing operations before restructuring was negative $36 million for the quarter.

Please turn to Slide 5. As we've told you, M2016 has specific targets in 4 key areas that we believe will drive achievement in our 3 metrics for EBITDA margin, net debt and revenue. I'll share a few highlights with you today, but we'll provide you with more detail about the plan at our Analyst Day in February.

Starting from the left, operational excellence represents the need to integrate lean concepts throughout our global manufacturing operation, with an emphasis on safety, quality, delivery and cost. We have defined targets for each of these performance indicators that we intend to achieve through continued diligence and execution of the Meritor production system. Not only are each of these measures important in terms of the well-being of our employees and the satisfactions of our customers, but they also impact our bottom line. In fiscal year 2013, we're proud to have had the best safety and quality performance in the past 6 years and the highest OE delivery performance in 3 years, with a 98% on-time delivery rate.

We're also taking steps to improve labor and burden year-over-year. In fiscal 2013, we were able to partially offset the $700 million market decline through restructuring actions, and we further reduced costs with a series of burden optimization actions.

The next pillar represents our clear priority on customer value. We plan to continue strengthening our relationships with our current customers, developing our relationships with new ones and substantially enhancing our product portfolio as we maximize Meritor value proposition in the market. We're confident in our ability to grow the company organically, and we'll highlight for you our wins last fiscal year with OEs in the 4 major regions of the world.

Related to product costs, we intend to drive reductions in net material performance using 3 different approaches. While commercial negotiations will always play a part in managing product costs, we're also actively engage in a best-country sourcing and technical innovation that we believe are more permanent cost-reduction strategies. We're devoting more resources to these strategic process that we anticipate will account for 2/3 of our material performance as we reach 2016.

Another key element is to increase inventory turns as the means to improve our working capital performance. Due to the inventory-intensive nature of our business, we typically run 7 to 8 turns a year. We believe we can improve that number.

Finally, we recognize that M2016 is only achievable if our team is engaged. I believe we have the right leadership team and required degree of commitment from our employees to create the level of sustainable performance improvement we want.

If you turn to Slide 6, we'll provide additional context around each of the 3 key metrics we've established. Our first financial metric is to achieve a 10% adjusted EBITDA margin. Historically, our cash flow breakeven level has been 7% to 7.5%. At 10%, we would generate meaningful cash flow, and that's our target for 2016. Specifically, we expect to generate 1.5 to 2 points of margin in the next 3 years through successful execution of non-volume-related actions. Even if volumes were to stay essentially flat, we are driving margin expansion and expected to be in an 8.5% to 9% margin in 3 years.

With some level of market recovery and new business wins, we expect to gain an additional 1 to 1.5 points of margin. Relative to prior years, sales were down in all regions this past year. As Kevin will discuss, we expect most of these markets to remain challenged in 2014. And while we remain bullish that global markets will strengthen during this 3-year time frame, our plan is not overly dependent on this recovery.

We are also developing a strong pipeline of new products that will drive increased sales during this period. We anticipate that regional market improvement combined with new business wins will increase our revenue to around $4.5 billion by 2016.

Let's turn to Slide 7. Our target is to reduce net debt, including retirement benefits, by $400 million by the end of fiscal year 2016. This 20% reduction on our debt levels, combined with a 10% margin target and revenue of $4.5 billion, would give us metrics on par with a BB credit rating. At this rating, we believe we'll optimize our cost of capital.

This past year, we achieved $217 million of net debt reduction through the sale of our 50% ownership in a Brazilian joint venture and steps we took to improve the funded status of our pension plans. We are halfway there, but we have more work to do.

On Slide 8, we're providing more color on our target of $500 million per year of incremental booked revenue at run rate. While we'll continue to manage the short-term cycles typical in this industry, we have the ability to grow beyond the peak cycles. We believe our strength in engineering and manufacturing combined with growing customer relationships and leading market positions will lead to organic growth independent of market recovery.

By the end of fiscal year 2016, we expect to secure new business wins, resulting in $500 million of revenue at run rate, of which $250 million we expect to be on our P&L. We're tracking ourselves against the $500 million and are proud to announce that in fiscal year 2013, we secured $120 million in new business wins. Of that, we expect to realize $110 million in revenue by the end of fiscal year 2016.

The wins we're highlighting today move us about 40% of the way to achieving the $250 million we expect in 2016. As you can see in the chart, the vast majority of this revenue will come from new business in South America, India and Europe. The wins we highlight in the next few slides represent the diversity of our growth opportunities.

On Slide 9, we highlight several axle wins with important customers in South America, including MAN, DAF, Ford and Mercedes. Today, we're pleased to announce a new contract with MAN for Phevos program. The majority of this business is a conquest win for Meritor to supply front and rear axles for this customer's 8 and 10-truck platforms.

Our local footprint in Brazil combined with extensive design and manufacturing expertise will enable us to supply axles for this contract that meet or exceed our customer's requirement of power density, efficiency, durability and reliability. As we told you last quarter, we'll also supply axles for DAF's new extra heavy-duty trucks to be built at its new plant in Brazil. This award further expands our relationship with Paccar globally.

If you turn to Slide 10, we're expanding our business in India with major customers in that region as well. Another new contract we're announcing today is with Tata Hitachi Construction Machinery, a joint venture between Tata Motors and Hitachi Construction. Meritor will supply axles for this customer's deep mining dump trucks.

Earlier this year, we told you about new business to supply axles for Ashok Leyland and Mahindra in the light commercial vehicle segment. To support these heavy-truck customers, on the lighter end of the range, we'll manufacture our 10X axle with cold-formed housing. This is the lightest-weight axle in our portfolio.

We also announced earlier this year our contract with Daimler India for Meritor's hub reduction axles. As global experts in hub reduction, we've localized this complex axle for India from our existing platform in Europe. We've said previously that we're excited about the long-term growth and potential. Although sales declined close to 40% year-over-year, we remain optimistic about the opportunities in this market.

Please turn to Slide 11. We announced earlier in fiscal year 2013 that we had secured new business with Volvo in North America for our EX+ air disc brakes. We also told you about a new disc brake program in Europe with a major OE. This contract also represents a conquest win for us.

We have significantly invested in our brake technical center and manufacturing operation in the United Kingdom, and we look forward to increasing our share of the air disc brakes in Europe over the next several years. As I said earlier, growing our top line with new customers and products is a primary focus for us. Our ability to meet our M2016 margin target requires organic growth.

As you can see, we are winning in the marketplace. We're getting conquest business, but we're not sitting still. We have a lot of work to do to achieve our objectives, but the important thing is we know what we need to do and have the plans to get there. With that, I'll turn it over to Kevin.

Kevin Nowlan

Thanks, Ike, and good morning, everyone. On today's call, I will provide a review of our fourth quarter and full year results, as well as our guidance for 2014.

Slide 12 compares our actual results for fiscal year 2013 to the outlook we provided on July 31. Sales for the year were just over $3.7 billion, which was slightly below the bottom end of our outlook. We had lower-than-anticipated sales in our India, South America and China markets, as these economies were slightly weaker-than-expected.

We delivered an adjusted EBITDA margin of 7.1%, or $261 million. Despite the revenue headwinds, we were able to deliver our margin guidance of approximately 7% through solid operational execution, continued net material performance, fixed cost reductions and aftermarket pricing actions. We earned $0.40 in adjusted earnings per share from continuing operations in 2013, which exceeded the upper end of our outlook. This was primarily due to the better mix of earnings from a tax perspective that resulted in a lower effective tax rate.

As Ike mentioned, we made a $54 million voluntary pension contribution in the last week of our fiscal year to prefund our 2014 requirements in the U.S. and U.K. Including this contribution, our reported free cash flow from continuing operations before restructuring was negative $109 million. However, our free cash flow guidance did not contemplate this opportunistic pension contribution, nor did it include the $33 million of withholding tax payments associated with the gain on sale of our ownership in Suspensys.

Excluding these 2 items, free cash flow from continuing operations before restructuring was negative $22 million, which was in line with our expectations. Although we experienced revenue headwinds in nearly every market we serve, we were able to deliver on our earnings guidance in 2013 through solid execution. This execution has created momentum in the organization to continue to drive margin performance in the face of near-term revenue headwinds.

It has also improved our operating leverage, which gives us confidence in our ability to improve margins as the global markets recover. On Slide 13, you will see our fourth quarter income statement from continuing operations compared to the prior year. We have also included a similar slide for the full year 2013 in the appendix for your convenience.

Sales of $909 million in the fourth quarter were down $77 million year-over-year, or 7.8%. The decrease in sales is primarily in the commercial truck and industrial segment and was driven by lower military sales, as the FMTV production continued its planned wind down. In addition, our production levels were lower in North America, China and India. These declines were partially offset by year-over-year increases in South America and Europe. In recent months, European production has been positively impacted by prebuy activity in advance of the Euro 6 emissions changeover scheduled for January 2014.

Gross margin as a percent of sales was 11.7% in the fourth quarter, an increase of 20 basis points year-over-year. This improvement includes a $5 million supplier recovery relating to the warranty contingency that we booked in the third quarter of 2013. We have excluded this recovery from adjusted EBITDA, consistent with the charge we took on this matter in the third fiscal quarter.

SG&A of $60 million was $20 million lower in the fourth quarter of 2013 versus the same period in 2012. As you'll recall, we executed a series of cost reduction actions earlier in the year, which favorably impacted both gross margin and SG&A on a year-over-year basis.

In addition, last year, we had higher year-end asbestos valuation adjustments, as we changed our actuarial assumptions related to our Rockwell liability to include a 10-year estimate of the liability versus the 4-year estimate we had been previously using.

Next, you'll see a line item related to pretax pension settlement loss of $73 million that we incurred in this past quarter. This noncash charge relates to pension buyouts of term-vested participants in our U.S. defined benefit pension plan. Consistent with our strategy to derisk our pension plans, the execution of these buyouts released the company of approximately $197 million of gross U.S. pension liabilities based on the 2012 pension valuation. Pension plan assets of $157 million were used to settle these liabilities, which resulted in a year-over-year improvement to the funded status of the U.S. Pension Plan of $40 million.

The corresponding loss associated with the settlement of the plan was noncash and relates primarily to the acceleration of previously unrecognized actuarial losses already reflected in book equity. Restructuring costs were $3 million favorable in the fourth quarter of 2013, which was primarily driven by the settlement of a lease obligation in China for less than the accrued liability, so we reversed the remaining reserve associated with the obligation.

In the fourth quarter, we completed the sale of our minority interest ownership in Suspensys. Gross proceeds for this transaction totaled $195 million, which resulted at net proceeds of $160 million after taxes and fees. This resulted in a pretax book gain of $125 million.

Earnings in our minority-owned affiliates were down $3 million year-over-year. This decrease was primarily driven by lower earnings from our joint venture in Mexico and by the loss of earnings from the sale of our investment in Brazil. Interest expense was $27 million in the fourth quarter of 2013, which is $4 million higher than the same period last year. This increase was caused by higher fixed-rate debt balances, primarily driven by the capital markets transactions executed in fiscal year 2013 to refinance and extend our debt maturities.

Income tax expense was up $38 million from the fourth quarter of 2012, due in large part to the $33 million of withholding taxes related to the Suspensys sale. Adjusted income from continuing operations was $11 million. Due to the unique and material items affecting our results in the quarter, adjusted income excludes the pension settlement loss, restructuring charges, the specific warranty recovery and the gain on sale. All of this resulted in $0.11 per share of adjusted income from continuing operations, compared to $0.32 in the same period last year.

On the next 2 slides, I will discuss the quarterly results for our 2 business segments. Slide 14 shows fourth quarter sales and segment EBITDA for commercial truck and industrial. Sales were $709 million in the fourth quarter of fiscal year 2013, down 10% relative to the same quarter in 2012. This sales decrease reflects lower military sales and OE production volumes in North America, China and India.

We did experience higher sales in Brazil year-over-year, as the fourth quarter 2012 production levels were still somewhat depressed due to the impact of the Euro 5 emissions standards. Europe was also up for us, which is due to increased order activity relating to the Euro 6 emissions change going into effect in January 2014.

Segment EBITDA decreased $9 million, driven by -- primarily by the lower sales. And segment EBITDA margin decreased to 7.6% compared to 8% in the prior year. Overall, we delivered a 12% downside conversion for this segment, which is better than the 15% to 20% range we typically generate.

The lower downside conversion was primarily driven by meaningful net material performance and cost improvement actions. Next, on Slide 15, we've summarized the Aftermarket & Trailer segment financial results. This segment demonstrated considerable year-over-year margin improvement. Fourth quarter sales were $233 million, $2 million higher than the fourth quarter of 2012. Despite the small increase in sales, segment EBITDA increased by $6 million and EBITDA margin increased 250 basis points year-over-year to 10.3%. This improved performance reflects the benefits associated with the pricing actions executed earlier this year and lower material and structural costs.

Overall, this performance reflects the efforts by the -- our aftermarket team to achieve the Meritor value proposition by ensuring we are properly compensated for the value we bring to the market. Moving to Slide 16, I'll take you through our sequential adjusted EBITDA walk from our third fiscal quarter of 2013 to the fourth quarter. We generated $87 million of EBITDA in our third quarter. Relative to the third quarter, our EBITDA was lower by $12 million, due to volume, mix and pricing. The decline in volume drove this number with normal downside conversion. However, the impact of the sequential volume decline was partially offset by positive pricing in our aftermarket business.

The Brazilian currency was a significant headwind in the fourth quarter, as the currency depreciated 10% from the third fiscal quarter to the fourth. That was the primary driver of the $6 million decrease quarter-over-quarter due to foreign exchange. The next item on the walk summarizes the impact associated with the reduction in earnings of our unconsolidated joint ventures.

About half of this relates to lower earnings due to the sale of Suspensys. Moving to the next line item, we experienced another quarter of sequential improvement in net material, labor and burden costs. This drove $6 million of higher EBITDA in the fourth quarter relative to the third quarter. Driving reductions in material cost and delivering operational excellence are key priorities underlying the M2016 plan. So we're pleased with our team's ability to continue to demonstrate strong performance here.

Next, you recall that in the third quarter we incurred $4 million of executive severance costs, which did not repeat in the fourth quarter. And finally, we had several year-end valuation and other adjustments resulting in a net EBITDA reduction of $3 million.

Overall, we generated adjusted EBITDA of $70 million and adjusted EBITDA margin of 7.7%. Our downside conversion was approximately 20%, in line with the typical 15% to 20% we've told you to expect with changes in revenue.

Now let's turn to Slide 17. For the fourth quarter, free cash flow from continuing operations before restructuring was negative $36 million, $73 million less than the same period last year. This lower year-over-year result is primarily due to the voluntary pension contribution and the income tax associated with the Suspensys sale that I previously discussed. Excluding these 2 items, we generated strong positive cash flow in the quarter, driven primarily by positive earnings and good working capital performance.

Total free cash flow for the fourth quarter of 2013 was negative $46 million, $77 million below last year, mainly due to the items I just mentioned. Now let's turn to Slide 18 for a review of our liquidity and debt maturity profile.

We ended the fourth quarter with $817 million of liquidity, including $318 million of cash on hand. These are the year-end balances even after the impact of repaying $45 million of term loan debt and opportunistically prefunding our required 2014 pension contributions.

Our liquidity position in relation to revenue is 22%, which is higher than our targeted range of 15% to 18%. You should expect that we will continue to use any excess liquidity to pay down debt and debt-like liabilities, consistent with our M2016 strategy. Throughout the year, we've been proactive and opportunistic in managing our debt maturity profile. We executed several capital markets transactions that now provide us with a relatively clear runway before any significant funded debt matures.

Over the next 3 years, we only have $154 million of debt maturing, which we believe is very manageable, particularly given our strong liquidity profile. Next, I'd like to review our global market outlook for fiscal year 2014 on Slide 19. In the upper left, we've provided our fiscal year 2014 North America industry forecast for medium- and heavy-duty truck volumes. As you can see, we expect a stable and solid truck market in fiscal 2014. The backlog-to-build ratio for Class 8 trucks remains fairly consistent at 3.7 months and cancellation rates have continued to decline. The North America truck freight tonnage metrics are stable and are trending slightly upward, with an estimated increase in GDP of 2%.

As a result of this market backdrop, we are forecasting a heavy-duty truck market of 245,000 to 255,000 units, which is up slightly from 2013 levels. Our forecast for the medium-duty and U.S. trailer market is also up slightly year-over-year.

In South America, we are forecasting the medium- and heavy-duty truck market to be down slightly from 2013. Given the economic uncertainty over the last 2 quarters, the economy in Brazil has not recovered to levels we expect over the longer term. On a positive note, the Finance Ministry announced in early October that it will extend the financing incentives designed to stimulate truck and bus sales through 2014. With that backdrop, our fiscal year 2014 forecast for medium- and heavy-duty truck production is at 175,000 to 185,000 units, which at the midpoint is down 3% year-over-year. That said, some of the new business wins that I spoke about in Brazil will have an impact on 2014. So while industry production may be down, we expect our revenue to increase. In Western Europe, we are forecasting the medium- and heavy-duty truck industry volumes to increase modestly in 2014. We do expect prebuy activities to continue through our first fiscal quarter.

While this prebuy is likely to be a headwind in our second and possibly third fiscal quarters, keep in mind that we are jumping off relatively weak 2013 production levels. In addition, the OEs are expressing some optimism as we move through the back half of the year, and we do see certain economic indicators in Europe improving. There is a risk to this forecast, however, particularly given the uncertainty related to the effects of the prebuy. But at this point, we do expect a modest uptick in production in 2014, resulting in a forecast for medium- and heavy-duty truck production of 365,000 to 375,000 units, which is a 4% increase year-over-year.

Turning to China, the mining segment is expected to remain at depressed levels in 2014. As we provide a lot of axle content for manufacturers of cranes and mining equipment, we are not planning for any meaningful recovery in China next year. We do believe, however, that we have reached bottom and our forecasted revenue will be flat year-over-year. We continue to follow recent news reports that China may increase its future investment in infrastructure projects. If this develops, it could favorably impact the region's business in coming years, and it could have a direct impact on the segments in which we compete.

The Indian market continues to be depressed, and we really do not see any tailwinds on the horizon. While the elections in the spring of 2014 will hopefully create some catalyst, we are not planning on any improvements in the Indian market next year.

We expect the market to be down another 8% in 2014, given the current economic climate. As I previously said, we remain bullish on India longer term. We see this as an area for growth, which is why we continue to invest in our product portfolio to support our customer base in the region.

Finally, I want to spend a few minutes talking about our defense business. As we have discussed extensively, a big component of our defense business has been the FMTV, which is now winding down over the course of the next 12 months. Our revenue from the FMTV business will be down approximately 55%, or nearly $100 million, in 2014. With that said, we are focused on winning 2 significant military programs: The HMMWV Recap and JLTV. If we were to win both, they have the potential to generate combined revenues that would be higher than our peak FMTV revenue, albeit several years out.

From a timing perspective, the HMMWV Recap production award is expected to be announced in about 12 months. The JLTV program is currently in the engineering, manufacturing and development phase, which is expected to run through late 2014. The final selection for this program is targeted to be announced in late 2015.

Turning to Slide 20. Based on the demand assumptions we outlined on the preceding chart, we expect sales in fiscal year 2014 to be approximately $3.7 billion. On an aggregated basis, our OE and market assumptions would suggest a modest increase in revenue. However, that increase is expected to be more than offset by the decline in the FMTV business. The new business wins that I spoke about, particularly in Brazil and our EU brake business, will also provide a little bit of good news to offset the loss of FMTV sales. Taken all together, we think the result is relatively flat year-over-year revenue.

Despite the relatively flat revenue outlook, we expect to expand our EBITDA margin by approximately 40 basis points, to 7.5%. Keep in mind, this improvement would be accomplished in the year that our high-margin military business steps down 55%. We expect to drive this improved margin primarily through continued material labor and performance actions, combined with select pricing actions. This is consistent with the strategies underlying our M2016 initiative.

Adjusted earnings per share from continuing operations is expected to be $0.30 to $0.40, reflecting higher EBITDA margin and higher pretax earnings being more than offset by higher adjusted tax expense. The driver of higher tax expense is related to the mix of earnings, as we expect more relative improvement in taxpaying jurisdictions, such as China and Brazil.

In 2014, we are changing our approach to guidance for free cash flow. Consistent with our M2016 strategy of reducing net debt by $400 million, we will be measuring our cash flow performance on a total free cash flow basis. For 2014, we expect total free cash flow to be breakeven to $25 million positive.

We have also included our key planning assumptions for 2014 in the appendix for your convenience.

With that, I'd like to turn the call back over to Ike to provide some closing remarks around how the efforts underlying our fourth quarter performance reflect the demonstrated commitment to driving toward our key financial objectives for fiscal year 2016.

Ivor J. Evans

Thank you, Kevin.

Let's turn to Slide 21. You're now familiar with the 3 financial measures we've established for 2016. We're confident we will achieve these targets because we believe the fundamentals of this company are strong. We've recognized globally -- we're recognized globally for our capabilities in designing, testing and manufacturing the best drivetrain products available anywhere. With efficiency and safety in mind, our global engineering team works with the supply chain and manufacturing to offer a technology-rich portfolio of drivetrain solutions, localized by region when needed.

We effectively manage complexity for small volumes and aim to support our customer needs during periods of high volumes. The quality, durability and on-time delivery of our products has earned us the #1 market position in most of the markets we supply.

We're growing organically, as demonstrated by the contracts we told you about today with large and growing global customers. Today, we had a recognized brand requested by the largest OEs and commercial truck fleets in the world, a global distribution network for aftermarket products and unmatched support and service from DriveForce to Drivetrain Express.

M2016 represents the next step for us and provides the road map that will take us there. Our attention is focused on customers, products and process improvement. We're confident that if we remain committed to maximizing our performance in these areas, we'll be able to minimize the volatility inherent in this industry and achieve the targets we established to create greater value for our shareholders.

Thank you. And now we'll take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And please standby for your first question, which is from the line of Itay Michaeli from Citigroup.

Itay Michaeli - Citigroup Inc, Research Division

So just wanted to -- maybe we could start with a broad revenue walk between the $3.7 billion you've guided for, for fiscal '14 and your 2016 target. Maybe a little bit more detail around the cadence of the $110 million of revenue from the new book business, the visibility for the remainder of the total $250 million that you expect and then just maybe your overall global market assumptions to underpin that $4.5 billion target.

Ivor J. Evans

Of the $110 million, we'll see some of that start in our 2014 numbers. It's obviously more hockey stick towards '16, but it will gradually increase in '15 with the full $110 million in 2016. As far as the global markets, obviously, we were concerned. They are -- our end markets are our concern. We'd like to see them stronger. But again, we've put a plan together that is not overly dependent upon end market recovery. And that's the good thing about M2016, is that we think we can do -- we can really improve our bottom line with what we're doing internally and organically without end market help.

Itay Michaeli - Citigroup Inc, Research Division

Great. And then maybe a couple of free cash flow questions. One, what's embedded in the fiscal '14 outlook for pension contributions and cash restructuring? And then do you also have maybe, Kevin, the breakout between the pension and OPEB? I think you have it kind of both combined on Slide 17. If you have a breakout between the pension and OPEB that will be very helpful, too.

Kevin Nowlan

In terms of pension contributions in '14, it's about $11 million remaining. And we didn't prefund those because those tend to be pay-as-you-go plans. In terms of the pension and OPEB breakout, I'm going to have to get that for you out of the 10-K, I think, in terms of the breakdown. I think the pension -- I'm going to have to get that detail for you.

Operator

The next question is from the line of Colin Langan from UBS.

Colin Langan - UBS Investment Bank, Research Division

Firstly, any color on the Eaton trial? Any court date set at this point? And in terms of timing, I think you had previously mentioned the fall or kind of there. So is that going on now?

Ivor J. Evans

The 3 motions are still before the court. Unfortunately, a trial date has not been set. And other than that, I really can't provide any further updates, but that's the status. I mean, we're waiting for the judge to set a trial date, and that hasn't happened yet.

Colin Langan - UBS Investment Bank, Research Division

Okay. And can you give any color on your exposure to South America? I mean, I think some outlooks out there for Brazil are a bit more bearish. Just trying to get a gauge of, in your commercial segment, how big of an exposure there is there.

Ivor J. Evans

Jay, do you want to answer that question?

Jeffrey A. Craig

Sure. Yes. This is Jay Craig. Yes, I've just come back from Brazil in the last couple of weeks. And certainly, the market isn't recovering entirely to the levels we would have expected in the short term. As Kevin mentioned in his comments, we're still bullish on the long term. There are some segments of the market that are quite strong, due to the strong agriculture performance out of Brazil. And that tends to favor the very-heavy-truck segment because those are the vehicles required to move those goods. So you're seeing the heavy truck segment perform quite well there. And for the customers that we're aligned with, we're performing well there. But it's really the lighter heavies that has still experienced weakness since the emissions change, which caused a large price increase, which is still being digested by the market.

Colin Langan - UBS Investment Bank, Research Division

And any color on the percent of sales that are in your commercial segment from South America?

Jeffrey A. Craig

I'd leave that also to Kevin, but I don't think we disclose specifically what our...

Kevin Nowlan

We disclose it normally in the 10-K. I mean, I think if you look at our fiscal year '12, South America represented between 10% and 15% of revenue. And I think when you look at it again this year, you'll see it's probably in that same ZIP code.

Colin Langan - UBS Investment Bank, Research Division

Okay. And any color -- your tax rate seemed -- I mean, obviously, you have a lot jurisdictional issues. But, I mean, it seems like your guidance is implying almost an over 50% tax rate. Is that correct? And how do you think you can maybe get the tax rate back to a normal level over time?

Kevin Nowlan

Yes. I mean, the key for us to getting the tax rate to more normalized levels over time is to generate better earnings out of our jurisdictions in which we're not a taxpayer. Because, as you'll recall, we have valuation allowances in certain jurisdictions, like in the U.S. and through our Western Europe. Which means if we generate any losses in those jurisdictions, we're not able to recognize a tax benefit. So as the earnings profiles of those geographies improve, it improves our overall effective tax rate.

Colin Langan - UBS Investment Bank, Research Division

And my assumption that your tax guidance, the implied rate is over 50%, or am I...

Jeffrey A. Craig

We're not giving a specific guidance on the effective tax rate. But I think you can do some math that would suggest the effective tax rate is not going to be down to the normal levels we would hope to achieve over time.

Operator

The next question is from the line of Robert Kosowsky from Sidoti & Company.

Robert A. Kosowsky - Sidoti & Company, LLC

I'm just wondering on this M2016 plan you've had in place for a little bit of time now. We saw some nice margin expansion in the aftermarket side. And I'm wondering, if you can tell us like what stage of the game we're in as far as the margin expansion on aftermarket versus commercial truck?

Ivor J. Evans

We've done well with margin improvement around value-added offerings. But Pedro, do you want to add a little more color?

Pedro N. Ferro

Yes. As far as the aftermarket is concerned -- this is Pedro Ferro. We have done a strategic price. We have a large portfolio and we have internal goal now in parallel with the markets, as far as the total increase. But we have managed to change the pricing amongst the various items. And also the lower material cost, we have done a lot of work in optimizing material costs and best cost-country sourcing, as we said, and then the benefit of structural costing reductions in the beginning of the year as well. So...

Robert A. Kosowsky - Sidoti & Company, LLC

So does that mean is there still a lot more margin expansion opportunity on the aftermarket side? Or is the bulk of the 200 basis points is going to be coming on the commercial truck side?

Kevin Nowlan

Robert, it's Kevin. It's both. I mean, if we think about the key objectives that are really driving margin expansion in M2016, I mean, you have material -- or Meritor value proposition, which is really on both commercial truck in industrial, as well as aftermarket. I think aftermarket experienced some of the successes of that in '13, but there is more to come there. As you look at reduced material costs and better labor and burden performance, that crosses both segments as well. So I don't think you should assume that we're done in one segment or the other. There's more to come in both segments.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay, that's helpful. And then otherwise, for some of the new business that you're picking up, do we assume that it's margin accretive relative to your legacy business? And I understand regional kind of margin profiles differ, but is it generally -- a general rule that as you book a new business, it is margin accretive?

Ivor J. Evans

Well, without giving specific -- answering that specifically, the -- we -- the customers are -- our customers are recognizing the value of our product offerings. And I tried to outline that a little bit in my comments. These are good business wins.

Kevin Nowlan

And to that point, Robert, and you'll see it on the slide where we talk about our revenue outlook and our margin expansion over the next few years, I think it's fair to assume -- I think you'd be in the right ZIP code if you assume 15% to 20% incremental conversion on new business. Some are going to be higher, some are going to be in that range, at the lower end of that range. I think, overall, when we'd look at revenue increases up towards our 2016 targets, you should expect the incremental conversion to be in that range.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. And then 2 last questions. Do you have any update on the freight liner and Volvo contract negotiations?

Jeffrey A. Craig

This is Jay, Robert. I think we're making good progress with both customers right now. I would say the relationships we have with those customers are strong. And we're having good discussions about how we both optimize the value that we provide to those customers. And I think all of us are very pleased on both sides, both the Volvo side and Daimler North America side and our side, on the progress we're making there.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay, good. And then, finally, I just noticed CapEx looks like it's going to be up next year. And I was wondering what some of the things you're investing in are kind of accelerating some investments.

Ivor J. Evans

Well, it's basically, we didn't spend as much in '13. It's really at normalized level. So it's really not up versus where we've traditional been. But from a modeling standpoint, you can be in that $70 million, $80 million range.

Operator

The next question is from the line of Ryan Brinkman from JPMorgan.

Ryan J. Brinkman - JP Morgan Chase & Co, Research Division

Given that you're forecasting free cash flow of only roughly breakeven plus $25 million in FY '14 and yet you have spoken repeatedly of the need to delever the business, are there any other actions that you're maybe contemplating taking in FY '14 to help to delever the business?

Kevin Nowlan

I mean, I think our guidance really contemplates what the planning is for fiscal year '14. Keep in mind, as we talked about and Ike mentioned, we've historically had a breakeven of around 7% to 7.5%. So as we're migrating toward our 10% objective over the next couple of years, which will allow it to generate meaningful cash flow, we're still at a stage -- we're at 7.5% --- we are not throwing off a lot of cash flow. But as we see the margin expansion and the recovery of the end markets, we would expect to see that free cash flow improve even more.

Ryan J. Brinkman - JP Morgan Chase & Co, Research Division

Okay, great. I was just thinking if there were any sort of other things you had in your back pocket, like the sale of Suspensys, for example, if there's anything else that you could sort of strategically -- levers you could pull strategically to help delever the business, apart from like any settlement or anything along those lines or just kind of the free cash flow?

Kevin Nowlan

I think right now, we're really focused on those M2016 strategies that Ike talked about earlier. That's really where the focus is as we head into '14.

Ryan J. Brinkman - JP Morgan Chase & Co, Research Division

Okay, great. And then can you share what your mandatory or maybe any sort of planned discretionary contributions are in FY '14 and to the pension plan? And are those embedded in the free cash flow outlook?

Kevin Nowlan

Yes. The plan contribution, we had -- we expect another $11 million of pension contributions that we'll be making over the course of the year. The $54 million was -- that we funded at the end of last year was really what was mandatory to be contributed this year. The $11 million really represents primarily pay-as-you-go plans in some of our international jurisdictions. So the assumption embedded in our free cash flow is another $11 million of pension contributions.

Ryan J. Brinkman - JP Morgan Chase & Co, Research Division

Okay, that's really helpful. And then just on some of the end markets, China flat versus down 40. What are you seeing there in terms of stabilization to maybe get you a little encouraged? And then on your outlook for 5 through 8 in trailers for North America, obviously, you're looking for a little bit of improvement there. But do you still believe in the idea of large pent-up demand, meaning that volumes could be significantly higher, for example, say, in FY '15, if not in FY '14?

Ivor J. Evans

We've given you our best estimate of what we think these markets will be. We've tried to be conservative. But your thoughts as to where these end markets are is as good as ours in that sense. We're at lower levels. I mean -- and the good news is that we are executing really, really well in markets that are depressed and at the lower end. So any kind of upswings that we see in any of these markets is a positive.

Ryan J. Brinkman - JP Morgan Chase & Co, Research Division

Okay. Then just last question. Your guidance seems to imply roughly $17 million higher EBITDA year-over-year, some margin expansion on flat sales, and I'm sure you can do that, given your stronger execution in the face of the revenue declines just last year. But can you just kind of help us on where that improvement comes from next year? Is it pricing? Is it cost saves? Is it mix? Is it a combination of these factors? What are the rough buckets?

Ivor J. Evans

Yes, it's a combination of. We are seeing some pricing, particularly with our aftermarket. But we've also continued to perform on our net material and labor and burden areas as well. So it's a combination of all those things.

Operator

The next question is from the line of Doug Karson from Bank of America Merrill Lynch.

Douglas Karson - BofA Merrill Lynch, Research Division

As I look out to 2016, the strategy to achieve 10% adjusted EBITDA margins, can you maybe give us a flavor of like the cadence? Is that going to be like back-end loaded or could we see maybe material improvement in 2015?

Kevin Nowlan

It's really a mix. I mean, as you think about some of the different elements. As you look at material, labor and burden performance, for instance, we expect to see steady progression on those each year as we move forward. As we look at some of the other things on pricing actions or even on some of the new business wins, they tend to be more back-end loaded. So I think you should expect to see sequential improvement as we head into '14, '15 and '16, but it's not going to be a straight line.

Ivor J. Evans

But the good news is we've got $110 million towards the $250 million goal, the $250 million we expect to hit in 2016. So we're 40% of the way there on that. And just to reiterate what Kevin says, we are seeing steady performance on the labor, burden and material area. Some of the pricing from aftermarket probably is a little more in '14, '15 as opposed to '16.

Douglas Karson - BofA Merrill Lynch, Research Division

Right. I guess, my question here would be on capacity utilization. I've been following the sector for quite some time. And getting the capacity utilization right, it seems to be difficult for much in the an industry. How is your capacity utilization right now kind of heading into 2014? Is it where you need to be, given the outlook on what you could think 2015 could hold?

Ivor J. Evans

Well, the answer -- the quick answer is yes. But, Jay, do you want to add a little more color?

Jeffrey A. Craig

Sure. I mean, it's really consistent with what we see in the outlook for the region. So if you look at North America, it's relatively normalized replacement demands. So we are comfortable with the capacity utilization at that level. We certainly are comfortable that we could flex to higher levels there, if required. I think in Europe, there's a pretty strong prebuy going on right now. So the capacity is not, although 100% utilized, being utilized at a fairly high level. And then as we look at South America, we are probably operating at slightly lower levels than we would expect to. And certainly in China and India, it's probably far below what our capacity is right now. And we've taken actions there to align our variable and fixed costs in line with what we're seeing right now.

Douglas Karson - BofA Merrill Lynch, Research Division

Okay. And then -- and finally, on the free cash flow side, it looks like we're going to be either reasonably close to breakeven in the coming year. But as we head out to 2016, I'm assuming we'll be cash flow positive. Do you have any ideas of how you'd deploy that cash flow? Would it be acquisitions, CapEx, trying to delever? Or am I getting too ahead of the plan here?

Kevin Nowlan

No, you're not getting ahead. I mean, that's -- you're right on point. I mean, we are expecting to generate positive cash flow as we get through the fiscal '16, M2016 plan. And we expect to deploy that cash flow, primarily to reduce our debt and debt-like liabilities so that we can target achieving BB credit metrics.

Operator

The next question is from Kirk Ludtke from CRT Capital Group.

Kirk Ludtke - CRT Capital Group LLC, Research Division

With respect to the Eaton litigation. You mentioned that there's really no trial date set. And I'm just curious, is there a -- can you help us with the time line for the litigation potentially? Or are you kind of getting out of the -- trying to predict what this judge is going to do?

Ivor J. Evans

We -- you said it well. I would love for this to have moved at a faster pace. But we're dependent upon the trial judge to set a trial date, and she hasn't done it yet.

Kirk Ludtke - CRT Capital Group LLC, Research Division

Is there -- when you think about what would be a reasonable time line for -- when does -- is there any kind of way to gauge what the particular time line...

Ivor J. Evans

Well, we've been wrong at every pass so far. Initially, we thought at early fall, and then we would say maybe late fall. It hasn't happened yet. So your guess on this one is as good as ours and as good as our outside counsel who is helping with this. So we're just dependent upon Judge Robinson to set a date.

Kirk Ludtke - CRT Capital Group LLC, Research Division

Okay, that's helpful. With respect to the HMMWV upgrade, you said something was going to happen in the next 12 months, and I missed it.

Ivor J. Evans

Jay, do you want to talk...

Jeffrey A. Craig

Yes, we're expecting a decision out of the Marines, so sometime in the next 12 months on that product. And so we're still -- I think we are very well positioned on 2 of the 4 down-selected programs. And so I think we're very pleased with our positioning there and our -- the vehicles we're aligned with are performing very, very well.

Ivor J. Evans

I might add a little bit to Jay's comment. Even though that this one does not require congressional approval, there is always an element of risk with the political process, so just as that as a caveat.

Kirk Ludtke - CRT Capital Group LLC, Research Division

Right, I appreciate that. And when -- what would be the earliest this program would go into production, do you think?

Kevin Nowlan

2015. I think it'd be probably a slow ramp-up in the early part of 2015, but then we -- but we would start to see production potentially in '15.

Kirk Ludtke - CRT Capital Group LLC, Research Division

Okay, great. And back to the 2014 guidance for a second. You highlighted that the prebuy in Europe a couple of times. And is -- can you give us a sense for how much of the total annual production will be in the December quarter of the 3 60 for...

Kevin Nowlan

We're not really providing any guidance by quarter at this point. But you can imagine, the prebuy does have a benefit on the year overall as we think of the first quarter on a year-over-year basis.

Ivor J. Evans

Well, the good news in Europe, we've seen a prebuy and we are seeing some strengthening in the European markets, particularly the Northern Europe. So -- but we can't provide specific guidance for the quarter.

Kirk Ludtke - CRT Capital Group LLC, Research Division

Okay. And then just a couple follow-ups on the other cash flow items. Did you mention pension expense in 2014? I know that funding is 11, but...

Kevin Nowlan

I didn't mention pension expense. It will be de minimis in the year. I don't have the exact number in front of me, but it's virtually nothing.

Kirk Ludtke - CRT Capital Group LLC, Research Division

Okay. And restructuring and working capital? I think you mentioned working capital would be a source, but I'm sure if...

Kevin Nowlan

We didn't comment one way or the other. I think it's all contemplated in the 0 to $25 million. And the same with restructuring. Historically, we've given some estimate of the restructuring bucket because it's been outside of our free cash guidance. But this year, we are giving free cash guidance in totality, inclusive of restructuring or anything else. So I think you should just assume those are all pieces or potential elements of the 0 to $25 million of guidance.

Operator

I would now like to turn the call over to Mr. Carl Anderson for closing remarks.

Carl Anderson

Thank you for your participation in today's call. If you do have any additional questions, please feel free to reach out to me directly. And with that, we will conclude our fourth quarter and fiscal year 2013 earnings call. Thank you.

Operator

Thank you for joining today's conference. This concludes the presentation. You may now disconnect, and have a very good day.

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