Allison Transmission Holdings' CEO Discusses Q1 2014 Results - Earnings Call Transcript

| About: Allison Transmission (ALSN)

Allison Transmission Holdings Inc. (NYSE:ALSN)

Q1 2014 Earnings Conference Call

April 17, 2014 8:00 AM ET

Executives

David Graziosi – EVP, CFO and Treasurer

Larry Dewey – Chairman, President and CEO

Analysts

Joe Vruwink – Robert W. Baird

Jerry Revich – Goldman Sachs

Andrew Buscaglia – Credit Suisse

Andrew Kaplowitz – Barclays

Vishal Shah – Deutsche Bank

Rob Wertheimer – Vertical Research Partners

Neil Frohnapplen – Longbow Research

Ann Duignan – JP Morgan

Alex Potter – Piper Jaffray

Tim Thein – Citigroup

Michael Feniger – Bank of America/ Merrill Lynch

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission’s First Quarter 2014 Earnings Conference Call. My name is Melissa, and I will be your conference operator today. At this time, all participants are in a listen-only mode. After prepared remarks, the management from Allison Transmission will conduct a question-and-answer session. Conference participants will be given instructions at that time. As a reminder, this conference call is being recorded. (Operator Instructions)

I would now like to turn the conference call over to Dave Graziosi, the company’s Executive Vice President and Chief Financial Officer. Please go ahead sir.

David Graziosi

Thank you, Melissa. Good afternoon and thank you for joining us for our first quarter 2014 results conference call. With me this morning is Larry Dewey, Allison Transmission’s Chairman, President and Chief Executive Officer. As a reminder, this conference call, webcast and the presentation we are using this morning are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through April 24.

As shown on Page 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These forward-looking statements are subject to known and unknown risks, including those set forth in our first quarter 2014 results press release and our Annual Report on Form 10-K for the year ended December 31, 2013, and uncertainties and other factors, as well as general economic conditions. Should one or more of these risks or uncertainties materialize or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those we express today.

In addition, as noted on Page 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached as an appendix to the presentation and to our first quarter 2014 results press release, both of which are posted on the Investor Relations section of our website.

Today’s call is set to end at 9:00 A.M. Eastern Time. In order to maximize participation opportunities on the call, please limit your questions to one with one follow-up question.

Now I’ll turn the call over to Larry Dewey.

Larry Dewey

Thank you, Dave. Good morning, and thank you everyone for joining us today. I’ll apologize in advance, I’m fighting the tailwind of a once in a decade spring cold, so my voice maybe a little froggy at times.

Our first quarter 2014 results are within the full year guidance ranges we provided to the market on February 13. Net sales improved on a year-over-year basis for the second consecutive quarter. Continued recovery in the North American On-Highway end market and higher demand for global Service Parts are encouraging, and consistent with our full year guidance which we are affirming.

Highlighting our commitment to return of capital to Allison shareholders, we completed a $100 million share repurchase, and paid a quarterly dividend of $0.12 per share.

Please turn to Slide 4 of the presentation for the call agenda. On today’s call, I’ll provide you with an overview of our first quarter performance, including sales by end market. Dave will review the first quarter financial performance, including adjusted EBITDA and adjusted free cash flow. I’ll wrap up the prepared comments with the full year 2014 guidance update prior to Q&A.

Please turn to Slide 5 of the presentation for the Q1 2014 performance summary. Net sales increased approximately 8% from the same period in 2013, principally driven by continued recovery in the North America On-Highway end market and higher demand in the Service Parts, Support Equipment & Other end market, partially offset by previously contemplated reductions in U.S. Defense spending.

Gross margin for the quarter was 45.1%, an increase of 170 basis points from a gross margin of 43.4% for the same period in 2013. The increase in gross profit from the same period in 2013 was principally driven by increased net sales.

Adjusted net income increased $28 million from the same period in 2013, principally driven by increased adjusted EBITDA.

Adjusted free cash flow increased $43 million from the same period in 2013, principally driven by increased net cash provided by operating activities, decreased capital expenditures and a $3 million reduction in technology-related license expenses.

Please turn to Slide 6 of the presentation for the Q1 2014 sales performance summary. North America On-Highway end market net sales were up 24% from the same period in 2013, principally driven by higher demand for Rugged Duty Series, Highway Series and Pupil Transport/Shuttle Series models, and up 11% on a sequential basis principally driven by higher demand for Rugged Duty Series and Pupil Transport/Shuttle Series models.

North America Hybrid-Propulsion Systems for Transit Bus end market net sales were down 23% from the same period in 2013, and 25% sequentially, principally driven by lower demand due to engine emissions improvements and non-hybrid alternatives that generally require a fully automatic transmission, for example natural gas.

North America Off-Highway end market net sales were up 50% from the same period in 2013, principally driven by higher demand from hydraulic fracturing applications, and down 14% on a sequential basis, principally driven by the precipitous rate of improvement in demand from hydraulic fracturing applications, including some new units used in refurbishment activities experienced in the fourth quarter of 2013.

Defense end market net sales were down 40% from the same period in 2013 and 3% sequentially, principally driven by previously contemplated reductions in U.S. Defense spending to longer term averages experienced during periods without active conflicts.

Outside North America On-Highway end market net sales were up 3% from the same period in 2013, reflecting strength in China bus, partially offset by weakness in Europe truck due to fourth quarter 2013 Euro VI emissions pre-buy activities, and down 26% on a sequential basis, principally driven by fourth quarter 2013 strong China bus tender timing and European truck Euro VI emissions pre-buy activities.

Outside North America Off-Highway end market net sales were flat compared to the same period in 2013, principally driven by modestly improved demand conditions in the mining sector, offsetting lower demand from the energy sector, and up 50% on a sequential basis, principally driven by modestly improved demand conditions in the mining sector.

Service Parts, Support Equipment & Other end market net sales were up 18% from the same period in 2013, principally driven by higher demand for global service parts and global On-Highway support equipment commensurate with increased transmission unit volumes, and up 6% on a sequential basis principally driven by higher demand for global service products and the same support equipment.

Now, I’ll turn the call back over to Dave Graziosi.

David Graziosi

Thank you, Larry. Please turn to Slide 7 of the presentation for the Q1 2014 financial performance summary. Given Larry’s comments, I’ll focus on other income statement line items and adjusted EBITDA.

Selling, general and administrative expenses decreased $5 million from the same period in 2013, principally driven by $5 million reduction in intangible asset amortization.

Engineering, research and development expenses decreased $4 million from the same period in 2013, principally driven by $3 million reduction in technology-related license expenses.

Interest expense net increased $1 million from the same period in 2013, principally driven by less favorable mark-to-market adjustments for our interest rate derivatives, partially offset by debt repayments, reduced amortization and deferred financing charges, the maturity of certain interest rate swaps and lower rates on our senior secured credit facility.

Other expense net decreased $3 million from the same period in 2013, principally driven by the 2013 loss on investments and technology-related initiatives. Income tax expense for the first quarter of 2014 was $27 million resulting in an effective tax rate of 34% versus an effective tax rate of 38% in the first quarter of 2013. The effective tax rate reduction was principally driven by a 2013 discrete expense items and a prior period statutory change in a state apportionment rate recorded in the first quarter of 2014.

Adjusted EBITDA for the quarter was $166 million or $33.6% of net sales, compared to $141 million or 30.8% of net sales for the same period in 2013. The increase was principally driven by increased net sales and a $3 million reduction in technology-related license expenses.

Please turn to Slide 8 of the presentation for the Q1 2014 cash flow performance summary. In view of Larry’s comments, I’ll focus on specific cash flow activity during the first quarter. Allison continued to demonstrate a solid free cash flow conversion and a capital allocation policy focused on the return of capital to shareholders, while pursuing a prudent level of net leverage. In addition, we enhanced our liquidity profile and capital allocation flexibility by increasing Allison for revolving credit facility commitments from $410 million to $465 million.

Finally, Allison ended the quarter with $160 million of cash, $453 million of revolver availability and net leverage of 3.86.

Now I’ll turn the call back over to Larry.

Larry Dewey

Please turn to Slide 9 of the presentation for the full year 2014 guidance update. We are affirming our full year 2014 guidance release to the market on February 13. Net sales increase in the range of 3% to 6%, and adjusted EBITDA margin, excluding technology-related license expenses in the range of 32% to 34%. And an adjusted free cash flow in the range of $375 million to $425 million. Capital expenditures in the range of $60 million to $70 million, and cash income taxes in the range of $10 million to $15 million.

Although we are not providing specific second quarter 2014 guidance, Allison expects second quarter net sales to be higher than the same period in 2013. The anticipated year-over-year increase in second quarter net sales is expected to be principally driven by higher demand in the North America On-Highway, North America Off-Highway and Service Parts, Support Equipment & Other end markets, partially offset by previously contemplated reductions in Defense net sales.

Thank you for your time this morning. Melissa, please open the call for questions.

Question-and-Answer Session

Operator

Thank you. At this time, we’ll be conducting question-and-answer session. (Operator Instructions) As a reminder, we ask that you limit yourself to one question and one follow-up. One moment please while we poll for questions. Our first question comes from the line of David Leiker with Robert W. Baird. Please proceed with your question.

Joe Vruwink – Robert W. Baird

Hi good morning. This is Joe Vruwink on the line for David.

Larry Dewey

Good morning, Joe.

Joe Vruwink – Robert W. Baird

I wanted to start, what sort of scenario needs to play out at this point for Allison to be at the low end of the full year ranges? I understand the exposure to volatile markets, but just given how Q1 started, the Q2 outlook, the fact that your higher margin businesses are the ones growing quickly. It just feels like for the year, you’re in position to be firmly at the high end of your range.

David Graziosi

Well, yes certainly there is a lot of the year to go. Let me just kind of handicap some of the end markets here. We feel good about the North America end market, both in terms of the recovery, although frankly we’ve been down this before, the two steps forward and one step back. We feel good about some of the share initiatives that we’ve done.

Hybrid Transit Bus, we’ve got a couple of large orders there. And in one particular case, there are some issues between the OEM and the property. And to the extent that that causes a hiccup in that, that affects our shipments there. So that’s one that we’ve got on the radar screen.

To North America Off-Highway, we feel good about that in terms of some of the data we’re seeing on in the energy sector. If you look at the Henry Hub Monthly Natural Gas Spot Pricing, you’re up 19% year-over-year. You take a look at the underground storage level, where that sits versus a year ago, that feels good. There is a lot of chatter. And we’re waiting for those orders to materialize. So to the extent that they have either a better or slower pace, that can move it either way.

Probably the biggest areas that we’re concerned about are some of the specific geo-political situations in how they can impact our outside North America sales. If you take a look at some of the pre-buy, we think we’ve got our arms around that, understanding that and had comprehended that. But that will play out here. Second quarter will be key on that. We think a lot of that’s been digested in the first quarter, but the proof will be how we come out of the second quarter on that.

And then some of the other outside North America initiatives, we feel good about China bus. We got to see if the elections in India remove the block there to some of the orders. And we’ve got to see that happen. Russia obviously is challenged. We had some volume in there. So that’s an area that we’re watching very closely. Not only the domestic Russia market, but there was a large tender supplied by Russian OEMs to Venezuela. Venezuela and Argentina are clearly challenged areas.

So while there are clearly things we feel good about, and certainly we’re driving the things that are within our control. And those are few things hanging out there that would say that they could be some headwinds. And our intent is to push through those and be in the guidance range. And if some of those headwinds don’t materialize, yes, we’ll update the guidance accordingly.

Joe Vruwink – Robert W. Baird

Okay. And then just on one of the volatile markets, North America pressure pumping. Can you just kind of give a sense of activity? It seems like there is rigs moving back into certain regions like the Permian. I’d imagine your rebuild activity is probably stepping up if utilizations moving higher, but just a sense of whether the Q1 environment can continue going forward?

Larry Dewey

Yes, well we have – and you’re exactly right in terms of some of the activity which is encouraging, getting the rigs we’ve set all along, couple of things have to happen. The rigs got to get back in service and those that are idle and then those that need to repair will need to be repaired and put back into service before they start ordering significant quantities of new rigs. And in fact as you point out, as some of the data would suggest, we’re starting to see some rigs go back into service, those were idle.

We are seeing a step-up in our Off-Highway Service Parts. So that would suggest that the activity in the scenario you’re describing plays out. The question is, does the underlying demand continue to increase to the point where we not only get the idle back, the repaired rigs back and then we start ordering new units.

And we’ve said, I think right from the beginning that second half is probably where we’d expect to see that, and we’re continuing to look as that being the outcome.

Joe Vruwink – Robert W. Baird

Okay, great. I’ll leave it there. Thank you guys.

Larry Dewey

Thanks.

Operator

Thank you. Our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.

Jerry Revich – Goldman Sachs

Good morning.

Larry Dewey

Good morning, Jerry.

Jerry Revich – Goldman Sachs

Your North America On-Highway shipments were up significantly more than industry production rates sequentially and year-over-year. I’m wondering if you could just give us more context from your seat. How much of that was inventory stocking versus share gains on TC10 or otherwise. And separately what kind of production rate increase have the Medium Duty OEMs communicated to you to ramp up in coming months?

Larry Dewey

Well, first off in terms of some of the increases where we have seen is in some of the commercial and lease rental, there are some large orders there that we’ve certainly done a nice job of capturing that business. You take a look at some of the big fleets and we’ve got very strong orders from the likes of Penske, Ryder penetrations that are essentially off of those orders which is up. We’ve had the lion’s share of those orders in recent history, but I think we’ve even improved on that here. So that’s been – some of the share gain, if you want to think about it that way that has driven our numbers above the industry.

So I would say TC10 while we’re encouraged by some of the customer interest, the reality is as we’ve said, those orders are going to be relatively small in comparison to the total industry as people go into that trial phase of purchasing a few units. So that probably hasn’t had a much of an impact.

The other thing we’re doing is we’ve indicated in the Class 8 straight truck is we have a very aggressive program here in the spring to attack conquest customers as we’ve done historically, but we’ve got a spring program here with the construction conquest program through April. That’s to trying to capture some of that incremental business in the peak buying season. So those are all things that would contribute.

In terms of what we’re hearing from the OEMs, and I’ll just try to give you a flavor, not necessarily identifying each individual OEM on regard for their plans. Certainly we’re seeing a bit of a mixed bag, although on balance, it feels good. We’ve got one of our larger folks that have indicated Medium Duty backlogs stronger. They feel the Medium Duty business is sustainable, although if you look at ACT, there are couple of observations. Number one; the absolute level of inventory has stabilized. Having said that, because of the increased sales ratio, the inventory of the retail sales which is something we track.

We don’t focus a lot on the backorder data because we don’t think it’s really reliable. But that is well within the range, and frankly to the lower end of the range, meaning it certainly would sustain the current level of build that might suggest some increases as we have forecast.

We’ve got some other folks that are – while they’re seeing some strengthening in municipal orders for their business, their line sets are out as far as some of the others in the Medium Duty space. Heavy Duty space, we’ve got one of our major OEMs who has told their sales people and their dealers, they are sold out through June. At this point in time and it’s been a while since we’ve certainly had that scenario.

So kind of a mixed bag, but on balance we’re getting numbers in the schedules that would support some of the things that ACT is saying.

Jerry Revich – Goldman Sachs

And then – sorry, on your China On-Highway business, can you just talk about how the backlog is shaping up for the business this year. I know it can be lumpy biz on bus tenders. Can you just update us on the product rollouts and the availability rollouts and the year-over-year sales performance you had this quarter as well?

David Graziosi

Sure. China in the bus area, we’ve had a good first quarter performance. Some of that we got to be fair is couple of orders that slipped from the end of ‘13. Although that was very strong into the beginning of ‘14 you’ll recall. In ‘13 a lot of stuff got pushed to the end.

We do have some export business where China OEMs are going into places. In Latin America, that’s been a plus, as we look around the rest of that region. Korean volumes, down a little bit. Australia is still trying to come back from some of their economic challenges. China bus, we feel good. China truck, it’s all about getting those releases and building the customer demand. And we continue to drive at that.

Operator

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

Andrew Buscaglia – Credit Suisse

Hi guys. It’s Andrew Buscaglia on behalf of Jamie.

Larry Dewey

Hi Andrew.

Andrew Buscaglia – Credit Suisse

Hi. So on EBITDA margins, they look above target in Q1. What were some of the drivers specifically in Q1 that pushed them above that, above 32% to 34% range? And then I imagine it’s probably mixed, but how sustainable do you think that is going forward?

David Graziosi

Well, as we talked about guidance as we came into ‘14, we had the range 32% to 34% as we talked at the time as well. We’d like to see the year develop and then historically have updated our numbers and tightened, if you will. Some would view that as conservative rolling into the year. As we’ve said many times, we play for the full year. If you look specifically at Q1, the sales volumes certainly helps in terms of realizing some of the operating leverage benefits that we created back in ‘08 and ‘09.

It certainly also helps as an observation that we don’t provide specific margins by our seven end markets, but if you look at the growth on a year-over-year quarterly basis, they are in most of our higher margin end markets if you will, so that’s certainly a part of the story. As we look at the balance of the year, we’ve reaffirmed as we’ve said here the 32% to 34%. We’ve talked about the cyclicality with four quarters. Typically one of our weaker quarters for a number of reasons, the biggest one is the 5% to 10% less work days that happen in that quarter. So you think about the balance of the year playing out.

We, by influence from the guidance certainly believe that range is solid and you would have to conclude with the volume numbers that we have talked about for the full year and reaffirming that certainly Q2, Q3 would be the higher of the remaining three quarters. And I think those margins as we see the mix [ph] filling out as we’ve talked here this morning as well are going to be consistent with supporting the midpoint of that range.

So we are driving growth as Larry mentioned the outside North America initiatives around increasing penetration. We faced certainly some geo-political and regional challenges there for a number of reasons that we can’t per se control, but we can continue to push forward. So we’re going to drive our initiatives and the spending that we’ve planned for this year certainly ready to adjust if market conditions move dramatically in another direction, but overall we feel good about where we’re at from our ability to support the midpoint of that range this year in terms of margins.

Andrew Buscaglia – Credit Suisse

Okay, thanks. And then just specifically on Parts, which had a good quarter. Can you just talk about what the biggest drivers were behind the strengths there? And then which areas typically have the biggest impact on margins?

David Graziosi

Well as we’ve talked before Parts, Support Equipment & Other, we would – if you rank our end markets margins from highest to lower, the highest would be that particular end markets. That being said, sales up roughly $15 million for the first quarter year-over-year. Out of that $15 million, roughly $6 million of that is North America Off-Highway. Support Equipment is another $4 million. We had higher sellable engineering in the quarter as well for a few million. So the short story there is it’s consistent with what we’ve talked about in terms of margin performance for that end market, and also consistent with the ramp that we started to see entering in the second half of ‘13 in the North America Off-Highway market. Larry’s comments earlier in terms of where we see that moving continues to support an increased level of activity.

I would also state fairly that like many things, when you look at the history of that market would say, the rate of increase is not going to be linear per se. It’s going to be move around a bit. The amount of idled equipment that’s out there has to be absorbed. And I think that will have some impact on what we see both in the – to the aftermarket business as well as units, but we’re certainly prepared to supply as needed and have prepared our supply chain accordingly.

Operator

Thank you. Our next question comes from the line of Andrew Kaplowitz with Barclays. Please proceed with your question.

Andrew Kaplowitz – Barclays

Hi guys, nice quarter.

Larry Dewey

Thanks.

Andrew Kaplowitz – Barclays

Larry, can you talk about your non-North America Off-Highway business? We really kind of heard you before slight improvement in mining. Did something change in the quarter? Just does it bode well for stabilization or improvement in that business, and then talk about your energy business internationally as well?

Larry Dewey

Well, certainly one of the things we always have to keep in mind when we talk about percentages is what’s your baseline. And certainly we’re coming off challenging tail-end of ‘13. But we do feel there are some programs and we made a conscious initiative to work with SANY for example in China. And we’ve seen some nice orders out of there as they essentially at the vehicle level are engaged in challenging Cat in the Chinese market.

And so we’re aligned with SANY. And so that has been a source of some of our business. And then we’re in some niche applications where some of the smaller OEMs out of Europe. And we’ve seen again relatively small numbers but on a percentage basis, nice little pieces there, folks like through our distributor in Finland, Sandvik, through our distributor there, KESKO. Those are small numbers. The real big driver has been China. And it’s been driven by SANY for our 5000, 6000 and 8000 Series transmission in our Off-Highway product line.

Andrew Kaplowitz – Barclays

Okay Larry, that’s helpful. Can I go back to parts for a second? The number really stuck out to us has been – it’s little bit stronger than expected, and I know you have growth in that business, forecast of 5% and you did [indiscernible] first quarter. And I know you don’t want to update in each individual segment, but maybe talk about whether that was relatively stronger than you guys expected, and gives you pretty good confidence going through the year in that particular business?

David Graziosi

Yes, I mean look, as we do – we said it before, we started out the year we played for the full year. The guidance there specific to Parts and Support Equipment & Other end markets, many drivers as you know for that particular end markets. We’ve certainly at least picked up from prior cycles that some level of prudence and caution is required specific to the naphtha [ph] Off-Highway markets. And as you know that’s the majority – the vast majority of that market for us is energy. That tends to be very volatile and move around a fair bit, given the pretty I would say strong precipitous ramp rate that we saw in the second half of last year.

We certainly expected more growth this year as we talked about in terms of guidance. I would say, Q1 was a bit stronger than we were expecting. Having said that, we’re going to need to see some level of consistency in terms of run rate to I think make updates, if you will adjustments. And as I said earlier, part of that market is to be determined in terms of how quickly the equipment is going to come back into utilization and how we feel about those things, but certainly that was one of the positives, if you will, relative to our expectations in Q1.

Larry Dewey

The other thing is as those rigs get back into service, the level of that – for those rigs, I mean my definition mathematically, those refurbs are done. And so then it becomes a question. The service parts business becomes a question of affording those at the usage rates that they’re in.

So as you pull idle rigs out, there is going to be kind of a surge in the Service Parts and then it comes down to the more sustainable level based on usage, which would be good because of all of the aggressive usage as they’ve been proved utilization. And then we’ll move – then as we’ve said, we would expect the new unit sales then to come up. So you will see a little trade-off when we reach that inflection point when we start seeing new unit sales.

I suspect we will see a little moderation in the service parts. Having said that, we have some ideas on some upgrade kits that we’ve developed for existing units that might create an incentive for people to do some upgrades irrespective of the maintenance cycle. So we’re working on some of that.

Operator

Thank you. Our next question comes from the line of Vishal Shah with Deutsche Bank. Please proceed with your question.

Vishal Shah – Deutsche Bank

Yes, hi. Thanks for taking my question. I wanted to just talk to you about the free cash flow target for the year. It sounds like you guys see some good strength in the North American business. Can you talk about your priorities for free cash for this year? What percentage of your cash you think will be pay down versus cash that you expect to return to shareholders?

David Graziosi

Sure. The capital allocation model as we’ve talked about a bit, certainly the priority for us is getting cash back to our shareholders return, and also realizing returns on investments that have been made in the business as we’ve said from a medium-term target standpoint, net leverage of 3 to 3.5x. And then we have the quarterly dividend. I think as everybody knows at this point $0.12 a share, and the balance being available to shareholders. We’ve done several share repurchase here in the last year.

We don’t have a standing mandate from our board for those, but certainly something that we view as an option to get cash back to our shareholders. From a capital allocation model perspective, it continues to be very much focused on returning capital to our shareholders.

Vishal Shah – Deutsche Bank

Okay, that’s helpful. And can you talk about what you’re seeing in Europe. It sounds like that market is tracking a little better than expect. How do you see the next quarter shaping up?

David Graziosi

Well we certainly – the key to the next quarter is going to be have we wrung out the pre-buy activity. Are the guys – our folks back in at the level at a normal level. Certainly we saw some of that down take in the first quarter. And then the second quarter, will wring out whether that pre-buy was more significant than we’ve got baked in or whether our forecast will be tracking. There are some positive things.

We’ve put in our wholly-owned potentially a master distributor in the Middle East to try to create a stronger support mechanism, because we felt that was a feedback from potential customers was that was a barrier. And we have seen some additional orders out of Turkey including some military orders for the Turkish land forces as well as the Tunisian land forces.

We’ve got some bus tenders in Turkey. Scandia [ph] has won a deal and Dubai, of course which is where we’re located. So there has been a number of things in that region in the Middle East that have been positive. We’re seeing some activity in South Africa pickup a little bit with Bell. So that’s been a plus, but Western Europe proper – the key is going to be have we wrung out the pre-buy.

Operator

Thank you. Our next question comes from the line of Rob Wertheimer with Vertical Research Partners. Please proceed with your question.

Rob Wertheimer – Vertical Research Partners

Hi. Just one quick follow-up on the service and parts and aftermarket which you’ve discussed, and helpfully, I am just wondering on – I mean it’s a very nice sort of growing stream. Are you worried of all that as the fleets sort of gets renewed in North America that there is a curve, maybe that you’re consuming more parts than normal? I’m talking on On-Highway truck, or do you really see this as sort of a growing annuity especially as the fracking stuff initial surge or not, really curves into free build area [ph]?

Larry Dewey

One of the things that we saw over some several years is kind of a trade-off between the quality improvements we made in the Service Parts business. And we made some tremendous improvements, but the reality is you come so far down. I mean there is charts I can look at that say that the number of incidence is reduced by over 90%. Now we continue to work on it, but the amount of space you have, the number of issues is down. I mean we talk now over a handful of units on an issue, whereas before years ago, it was many more.

So the reality as I think now the fielded population is going to start with some lag of course. It’s going to start driving that number so that it’s – we think there is – it’s not explosive, but it will build on itself arithmetically as you go forward, but for a while there we were kind of flattish and that was really driven by the trade-off between quality improvement and then the subsequent field experience of those products, which is one of the reasons why we, I think have a pretty good position is people like the reliability in the products.

We were at a military recruiting activity yesterday. And one of those soldiers came up and had been driving one of the Allison equipped vehicles and they said that they had – sometimes people use in our industry the phrase, hey, it’s bulletproof, while the truth is it’s not, because this particular transmission had taken four bullet holes through the case. And they said, they were able to still drive at 15 miles to get out of harm’s way. So they were pretty pleased with that.

Now I am going back to make sure there wasn’t a warranty claim submitted on that but – so that’s – we think there is some growth driven by as we continue to drive the fielded population on.

Rob Wertheimer – Vertical Research Partners

That was great. Thank you. And then one minor follow-up on mining. Are you seeing delayed rebuild or delayed parts there, and is that coming back yet, and are you seeing many of your embedded transmissions parked?

Larry Dewey

Well certainly, it depends on where you’re at, but a general answer. The answer is yes. China certainly we saw that. We started making some headway. Probably want some time for a lot of service parts there, but certainly some of that equipment in the downturn was idle. I would say that as people don’t have as much activity – if you have a truck go down, you park that one. So yes, we’re seeing some of that.

It will be similar to – it’s different, but it’s similar to what we’ve seen in energy with the rig count that we talk about.

Operator

Thank you. Our next question comes from the line of Neil Frohnapplen with Longbow Research. Please proceed with your question.

Neil Frohnapplen – Longbow Research

Hi, good morning, and congrats on a nice quarter.

Larry Dewey

Thank you.

Neil Frohnapplen – Longbow Research

Are you anticipating SG&A to be flat to slightly up in 2014? And if you can just comment on the puts and takes around those line. And then I guess secondly, any change in R&D expense outlook? Just trying to get outside of changing mix, are there any cost wins – cost side wins versus the first quarter we should be thinking about as we move through the year?

David Graziosi

Sure. The SG&A, we’re not at this point updating guidance. As we talked about in February, roughly flat result more or less year-over-year, slightly up. If you look at engineering R&D, slight change down but relatively low, small changes year-over-year. And we continue as we talked about here this morning, the growth initiatives in driving those processes, we are in fact supporting with spending and continue to do that.

I would say on the cost side, the number of initiatives that we’re supporting. The supply chain as we focused there, I think – what happened a couple of years ago in terms of the trough in ‘08 and ‘09. The industry is still absorbing and understanding. It’s certainly receiving more of our attention as we think more strategically about our base going forward giving our volume placement versus alternatives for various suppliers.

We are thinking certainly more globally with our reach now through our Indian operations and sourcing from a global perspective, and thinking longer term about localization if you will, efforts and the benefits that go with that. So that’s included in our spending this year in various initiatives. And we think we’re continuing to make solid progress there with the team.

Larry Dewey

I would say, in terms of the year as Dave has talked about, we look at the year holistically. From a quarterly timing though, it would be fair to observe that marketing and selling activities much of which involve customers having the opportunity to drive Allison equipped vehicles and competitive product equipped vehicles in comparison testing. That tends to follow the good weather.

So in a number of our markets, certainly in the Northern hemisphere, that’s the second and third quarters. So I would expect timing of those expenses to be heavier in those periods. And then very often as you set up annual plans for your R&D activity, a lot of that gets tied to the hardware, certainly that occurs throughout the year, but probably heavier towards the later part of the year as people finish up the plan for the year.

So I would see some variation between quarters on that, but certainly for the year we’re tracking to plan.

Neil Frohnapplen – Longbow Research

Great, that’s helpful. And can you provide more granularity on the recent Ford announcement regarding its Medium Duty business. How will you look to replace those Class 6 to 7 volumes when they commence production this spring of ‘15, and do you anticipate any meaningful impact to your market share in longer term?

Larry Dewey

Well, I think they’ve got about 3% in that particular space is my data here that I’m looking at. We’ve already looked at what – how many units – we know how many units we sell them today. That certainly we knew they were looking at that. They used an automotive variant to come into the Class 4 and 5 as we’ve discussed. They are going to try – they’ve made one product change and try to stretch that further. Certainly that’s generated some dialog in the industry, a number of customers that we’ve converted to Allison Transmissions have indicated some level end users, now I am speaking of, have indicated some level of concern.

And so some other OEMs in that space have approached us. In fact, actually down at Mid America we had an announcement with Freightliner for example. And Hino is doing some work in that space. And so we’re working actively with those end users. We’re well ahead of any kind of introduction to get them the Allison product they want. And let’s not forget, it’s not just the Allison, it’s the Cummins engine, which is also very popular with these end users.

So our intention would be to work with those end users to make sure they get the power train components they want. And that will be – it will have to be based on Ford’s decision at this point in time in other chassis.

Operator

Thank you. Our next question comes from the line of Ann Duignan with JP Morgan. Please proceed with your question.

Ann Duignan – JP Morgan

Hi, good morning guys.

Larry Dewey

Good morning, Ann.

Ann Duignan – JP Morgan

Good morning. You didn’t talk about the natural gas as a driver of North American demand. Can you just give us some color there on what you’re seeing on the natural gas side?

David Graziosi

So certainly it continues probably with more substance and less fanfare however, everyone is talking about it initially. And I think they’ve executed their plans. So we are certainly seeing some activity in both the natural gas. We got some activity with Freightliner for propane equipped buses with Thomas Bus. So there is some activity there as well. It continues.

We certainly don’t see any abatement in fact, if anything I think they’ve gotten off to – as you all know, they’ve been able to achieve some nice volumes. And those volumes continue. We don’t see significant changes at this point in time despite some of the gas price increases. It may have moderated from growing further, but we don’t see anybody backing off at this point in time.

Ann Duignan – JP Morgan

Okay, that’s helpful color. And then you mentioned gaining share with SAMY against Caterpillar in China in mining. There has been some talk out there that Allison is using share to Caterpillar on the North America Off-Highway segment. Can you just address that and talk to us about what you’re seeing out there from a competitive environment on the Off-Highway side in North America?

Larry Dewey

Yes, specifically that would be energy, and there would be a couple of things. Certainly as different rig builders gain or lose, you can get different shares year-over-year. It would be fair to observe that the primary customer that Cat has did a little better, although it would appear that going forward, that could change a little bit here relative to the rig builder mix.

Certainly what we’ve done is we have – and it’s something we’ve been working on for a couple of years. Obviously you don’t do these things instantaneously. We’ve released some new products into the market that get us into the higher horsepower range, which Cat and Twin Disc – while it wasn’t a huge part of the business, it’s not the center slice, nonetheless, you’re looking at 10% to 15% and possibly growing to have that market onto yourself, certainly from their perspective I am sure they’ve enjoyed that. Well, that’s no longer going to be the case.

We’ve moved in with one product. We got another one that’s under active development and we anticipate introducing in ‘15. And frankly we’ve got some other stuff in the skunk-works that would go beyond that. So we’re certainly driving aggressively in that market and continue to – and will I think be even a stronger presence than we have been historically.

We’ve restructured that activity in our business. It gets even more of my time and attention personally, and that’s an area that we’re going to be going after pretty aggressively here.

Operator

Thank you. Our next question comes from the line of Alex Potter with Piper Jaffray. Please proceed with your question.

Alex Potter – Piper Jaffray

Hi guys.

Larry Dewey

Good morning.

Alex Potter – Piper Jaffray

I was wondering if I could question on AMTs. Obviously it seems as though in certain segments of the market penetration of AMTs is ramping relatively quickly. Just wanted to get a sense of whether or not you’re starting to bump up against AMTs in segments that had historically been dominated by Allison or whether you still think you’ve got kind of a good moat around the areas that you’re strongest in On-Highway?

Larry Dewey

Well, I would – if you permit me, I’ll change the metaphor just a little bit because the moat implies a defensive position. It would be more like we’re sending our troops into the field relative to our traditional markets. We’re looking to expand. And I think you saw some of that in the first quarter in our traditional markets, where we have seen and where it would be fair to observe.

When we went into the metro – as we go into the metro market – and by the way, we’re in there with some of our existing products in very low percentages one might say uncharacteristic Allison penetration, a handful of percentages which we’ll picking up a percent or two here or there. The TC10 has decided to go into that metro space. And that is probably where you’re seeing the most increase in AMT application, because it’s given – it’s a level of automaticity that has a chance of being acceptable in that market much more so than our traditional location markets.

So the traditional market is not so much. The issue will be as we go forward and as we’ve discussed we think there is and in fact we have data that’s very appealing vis-à-vis AMTs fuel economy data specifically, there is this AMTs in a metro market kind of application, but the fact of the matter is the AMTs are coming off of the manual architecture and the transmission that these customers in the metro market, the short haul market have been running for a while. And so their risk factor is lower. And so they are going to try the Allison to do two things.

Number one; verify that the fuel economy savings that they saw in the trial vehicles, the customer test vehicles is sustainable overtime. And then the other big thing is to say since it is a new product albeit from Allison, but it’s a new product, will that thing have the durability that they want. And if that’s the case with the fuel efficiency data that we have, I think we’ve got a proposition to capture a significant slice of that. And clearly the metro market will be knocking heads with AMTs demonstrating the value proposition versus that level of automaticity.

Alex Potter – Piper Jaffray

Okay, great. That’s helpful. I was wondering also too if we could just touch on Hybrid Bus quickly. It’s an area that I know that you guys haven’t really focused on as a growth driver potentially because of natural gas. I was just wondering what your view is there? Do you think that it’s something that declines and declines and declines until becoming almost not worth calling out because of the strength of natural gas, or is it something that eventually levels off, something that eventually ramps back up again? What’s your view strategically from a long-term standpoint?

David Graziosi

Well, we do – as we’ve described we see and coming off of the peak years and coming down to a lower level but kind of a sustainable level. You’ve got people that are still in that market picking up vehicles interestingly enough. There is some folks now in some of the coach business now that’s talking about that coaches and end up going into the city and they don’t agree because again they don’t have...

To use the nat gas, you got to have a fuelling station. They are not widespread. Now that can be done in a transit where you’ve got a lot of busses that come back to a depot, but even if that if you don’t have the nat gas installed, it’s pretty darn expensive to put in one of those stations. So we think that with everything we see today, including some level of interest in paraelectric, which is limited by the batteries. At the end of the day, and that’s what the hybrid allows you to do is recharge the batteries as you can with the paraelectric, but also you don’t have range anxiety because you don’t run out, you’ve got the internal combustion engine.

So even with that technology, look, CNG is great now based on the pricing, but you’ve seen the pricing rise. That’s another kind of boom and bust industry. And if prices jump high enough, the transit guys are quite adept and they can change over to find what is the lowest cost, total cost operating. They do have one other little challenge and that is they’ve got different colors of money.

There is some procurement money. There is operating expense money. And so with those chess pieces on the board, they’ll move around their purchases. The thing that we’re trying to do from a technology standpoint is, be present and use our technology development to have offerings whichever way the customer goes.

We can’t control some of those larger market forces, but what we can do is be positioned such that wherever that customer wants to move, we’re there for them. And so that’s our focus.

Operator

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

Tim Thein – Citigroup

Thanks guys. Good morning. So just on the – digging into the top line guidance of that 3% to 6%. I think last quarter you guys had outlined kind of a low double-digit growth rate for North America On-Highway. Obviously there has been some upward movement in terms of build plans in that two months subsequent. So can you just kind of update us in terms of what’s embedded in that 3% to 6% number for the total company?

David Graziosi

As we talked about in February, North America On-Highway will be 11% number for the year. Hybrid Transits down 23%, North America Off-Highway up 31%, Defense down 33%, Outside North America On-Highway up 10%, and then Outside North America Off-Highway up 30% and then about 5% growth in the Parts, Support Equipment end market. And obviously you now have the Q1 results.

I think we’ve talked here this morning about many of the drivers as we see them playing out for the balance of the year.

Safe to say North America overall looks stronger than we had anticipated if you look across those end markets if you will. Defense, we would debate at this point depending on some of the contracts being solidified with U.S. government again on the track side and that’s not something we can control at this point.

Outside North America, I think Larry touched on the significant points that we’re really focused on as we enter Q2 and what potentially impacts the business for the balance of the year. And I think as we put all of that into the mix as you would expect, there is puts and takes, but that 3% to 6% range for the full year is what we’ve affirmed. And again within the context of some of the individual drivers that we’ve talked about this morning, but again we’ll look to provide an update as we finish up the second quarter and provide those results and reassess where we are about this replay for the full year. That overall 3% to 6% at this point is where we are.

Tim Thein – Citigroup

Okay. And I am guessing you take that trade-off with North America On-Highway and the truck business is probably defense, you probably take that all day, but anyway separately on Parts, lot of focus there, but just curious, from memory that about half of that business is not covered under your long-term supply agreement. So can you just update us in terms of to extent this relevant strength persists what you’ve been able to do or what you anticipate being able to do on the pricing side within that Service Parts & Support segment?

David Graziosi

We typically go out on a manual basis more or less with that particular end market. So prices have already been listed for this year, communicated how our distributors and others and we’ll – as we do normal course, for us it would be to set as we get into the third quarter and start doing our budget plans for the year and assess market conditions. We’ll look to update there. I think it’s safe to say as we’ve talked many times, we are not in an automotive mode in terms of price downs etcetera so we continue to obtain full value for the Allison products including our parts and aftermarket business. And that’s something that we’re going to certainly push as we get into the analysis for the 2015 market conditions. And as Larry mentioned, some of the initiatives that we have in Off-Highway around kit package and some other things. And those are top of list for us in terms of driving through the market this year as well.

Larry Dewey

Just a point of clarification. We do not sell our service parts to the OEMs. We sell them through our independent service channel, our distributors and direct dealers who in turn support other dealers including OEM dealers. So it’s our independent two step distribution, which gives us our own access into the markets. So we don’t have those. So they are covered by supply agreements because we don’t sell to the OEMs.

Operator

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

Michael Feniger – Bank of America/ Merrill Lynch

Hi guys. It’s Mike Feniger, just filling in for Ross Gilardi of BofA. Just had one quick question. How are you guys seeing the environment for municipalities at this moment? Are you seeing municipalities just really replacing fleet, or is there any appetite you see them for expanding the fleet?

Larry Dewey

Look, almost all of it at this point in time is replacement. While things have improved and noticeably improved, the fact is there is, they’re still tight on their budgets. They still got people costs whether it’s pension or whatever. So you’re not seeing a lot of expansion in that arena. Now some municipalities are supplementing their baseline activity. They are not – we’re not seeing a trend towards significant outsourcing at this point in time, wholesale, because they’ve again got their own employment issues there with folks that are already on board, but it’s mostly replacement.

Michael Feniger – Bank of America/ Merrill Lynch

Got it. And then I guess my last question would just be on the appetite you’re seeing on the international energy market. You mentioned lower demand there. Is that just lumpiness or is there anything else going on there in terms of activity and demand?

Larry Dewey

Yes, it’s lumpiness. Particularly the Chinese went very aggressive, bought a bunch of products, have deployed it and now they are digesting that in essence.

Operator

Thank you. Mr. Dewey, there are no further questions at this time. I’d like to turn the call back to you for closing comments.

Larry Dewey

Well thanks. I want to again express our appreciation to everyone on the call. I appreciate the work you’ve done and so obviously the questions that you’re digging in. And we do appreciate that and appreciate the interest. And we’ll look forward to the second quarter call and updating the rest of the year. Thank you and enjoy your day.

Operator

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time. We thank you for your participation. Have a wonderful day.

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