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WABCO Holdings Inc (NYSE:WBC)

Q2 2014 Results Earnings Conference Call

July 25, 2014, 09:00 AM ET

Executives

Christian Fife - Vice President-Investor Relations and General Auditor

Jacques Esculier - Chairman and Chief Executive Officer

Prashanth Mahendra-Rajah - Chief Financial Officer

Analysts

Jerry Revich - Goldman Sachs

Jeffrey Hammond - KeyBanc Capital Markets

Justin Long - Stephens

Scott Group - Wolfe Research

Joe Vruwink - Baird

Larry De Maria - William Blair

Alex Potter - Piper Jaffray

Neil Frohnapple - Longbow Research

Operator

Good morning and welcome to the WABCO Holdings Second Quarter 2014 Earnings Conference Call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Christian Fife, Vice President Investor Relations and General Auditor. Sir, you may begin your conference.

Christian Fife

Thank you, Stephanie. Good morning everyone, and welcome to WABCO’s quarterly conference call. Today, we’ll present our second quarter 2014 results. With us this morning, we have Jacques Esculier, our Chairman and CEO; and Prashanth Mahendra-Rajah, our CFO. As a reminder, this call webcast and the presentation that we’re using this morning are available on our website, wabco-auto.com, under the heading WABCO Q2 2014 results. Replay of this call will be available through July 31.

Also, as shown on chart two of the presentation, certain forward-looking statements that we’ll make today are based on management’s good faith expectation and beliefs concerning future developments. As you know, actual results may differ materially from these expectations as a result of many factors. Examples of these factors can be found in our company’s Form 10-Q, which was filed with the SEC this morning and in our quarterly reports. Lastly, some of our remarks containing non-GAAP financial measures as defined by the SEC, reconciliations of the non-GAAP financial measures to the most comparable GAAP measures are attached as an appendix to this presentation and to our press release from this morning, both of which are posted on our website.

I will now turn the call over to Jacques Esculier.

Jacques Esculier

Thank you, Christian. Good morning and good afternoon to you all and welcome on our second quarter call. Before I jump into the results of our second quarter, I would like to kind of take the time to take a step back and look at the environment that we are dealing with. The world obviously continues to evolve in what I would call a fairly hectic and unpredictable way. There's really nothing new because we've seen it since we woke up out of this last major recession. But for our industry during the second quarter, the undefined conflict in Eastern Europe, the increased complexity that we see in the Middle East, and the increased financial disorder in South America, I think all of that contributed to a global erosion of the number of trucks and buses built during the second quarter by 5% down versus the second quarter a year ago.

And in this environment as you will see across this presentation, WABCO continues to deliver strong results to its shareholders and we do this by continuing to focus, first at outperforming the market.

You will see that in this erosion of volumes of truck and bus builds we are able to generate a 5.9% growth of our top line. We also continue to focus and adhering to our incremental margin model to transform top line growth into strong contribution to profitability and finally, we continue to transform net income into cash flow into free cash flow at a very high level of conversion.

So now moving to the numbers. As I said, we have during the second quarter raised our revenues year-over-year by 5.9% in local currencies or 8.4% reported. We generated gross profit margin of 31.6%, 1.1% for both last year. Performance operating income of $98.2 million or 13.4% margin versus $91.7 million a year ago, leading to a performance EPS of $1.42, $0.12 ahead with last year. I think I would like to highlight the fact that we are beating our previous record by $0.12 actually because the previous record was $1.03 per share which a year ago.

Free cash flow of $93.5 million, which leads to a conversion rates of 108%. We returned $100 million to shareholders through the repurchase of almost 1 million shares and as you will see at the end of this presentation, we will update our full-year 2014 guidance.

Moving to the next page will give you the profile of our growth of 5.9% excluding FX impact. First to our channels, starting with the OEM channel, selling to OE truck and bus manufacturers. Revenues are up 1% in our environment that is down 5% in volume year-over-year. And we are able to outperform in this channel by continuing to sell more technology, more content per vehicle across all regions and by continuing to gain share of market. The aftermarket channel generated a gross year-over-year of 14%. The Transics acquisition contributed 10% to it. Also, that performance was affected by lower revenues coming from Eastern Europe and Middle East.

Finally, sales to our joint ventures which consists mostly of the joint venture we have with Meritor in the United States has seen a gross of 27% prepared by a continuously strong market in the U.S. as well as a continuous improvement in the content per vehicle for WABCO ForEx system in that region of the world.

Then looking at the evolution of WABCO revenues versus the dynamics of markets in each region starting with Europe, the production of trucks and buses in Europe is estimated to have actually gone down 6% in Q2, 5% in Western Europe and 15% in Eastern Europe mostly Russia. So we outperformed the market by 1% through continuous penetration of technologies like stability control EMT.

North America has seen an increased production level year-over-year of 10% and 13% actually sequentially versus Q1. And we had outperformed this market by a very healthy 15% and that's mostly driven by again the increased penetration of technologies like collision mitigation systems which is our OnGuard product and AMT. South America has seen a dramatic 31% reduction in volume compared to a year ago or 17% further erosion compared to last quarter.

And we have been able to mitigate that major rapid drop and only drop our revenues by 29% continuing to actually increase our content per vehicle particularly around ABS.

Japan, Korea is a lot more stable. Market is up 3% year-over-year and we have began outperform by 7% due to a favorable vehicle mix and higher content per vehicle in Korea through hydraulic ABS.

China has seen an erosion of 6% year-over-year in production of trucks and buses or 4% sequentially versus Q1. And we have nicely outperformed market by 27% and that's driven again by increased content per vehicle, favorable vehicle mix and share of market improvements.

Finally, India has seen a erosion versus last year that continues to incrementally see a improvement in volumes by 3.5% versus Q1 and we have again nicely outperformed the market by 15% by continuing to introduce new products expansion of existing products as well as favorable vehicle mix. So as you can see overall, Q2 has seen a significant performance in gross and outperforming markets in every region of the globe.

Before I turn it to Prashanth to present to you all of the details of our financial results, I would like to take the opportunity to first thank Jason for having held the position of CFO during nine months in addition to being the controller of WABCO and the contribution that he brought during that time, I think is reflective of the potential that this young man has in his career. And I also want to welcome Prashanth, who you will see bring wealth of experience and capabilities that he has gained in his 25 years of career in the finest work through global assignment working for world-class companies like United Technologies, Visa or Applied Material. So Prashanth welcome. And it's yours.

Prashanth Mahendra-Rajah

Thank you, Jacques. Good morning, everyone. I'm excited to be joining you today. I'm excited because WABCO is a global technology leader with a long track record of excellent in execution. And after only two months on the job, I can sense from all the colleagues I've met from a dozen countries on three continents so far that there is a deep culture of excellence and execution. And I am truly looking forward to contributing to WABCO's ongoing success.

Now I'm going to take you through the financial results for the second quarter, so if we can start on page 5, I will walk through the details from sales to EPS for Q2. And I will focus predominantly on performance numbers. Performance numbers are adjusted to remove operational streamlining and separation costs, as well as costs associated with Transics acquisition as well as discrete and other tax items.

We have also adjusted comparisons to 2013 for currency translation. As Jacques just highlighted for you, we delivered strong organic sales growth in the quarter. Sales increased by around 6% in local currencies versus last year largely driven by our outperformance of the markets. Price reductions were contained to 1.2% which is within the range of what we've anticipated for the full year.

Our WABCO Operating systems continue to power excellence and execution across our organization. In Q2, it improved our results by generating 5.2% gross material productivity and our factories were able to generate 6.4% of conversion productivity, another strong result that helped us to more than offset 3.5 million of labor inflation.

In total, these continually strong productivity results generated a very healthy $19 million savings further demonstrating the ability of WABCO's Operating systems to optimize resources in a volatile environment. Volume, mix, and better fixed cost absorption generated around $15 million of additional gross profit. This resulted in a performance gross profit margin of 31.6% for the quarter.

Moving onto operating expenses, we continue to invest in research and development to support our long-term innovation and growth strategies which added $5.5 million to our costs. In addition, labor inflation increased operating expense by $3.4 million in the second quarter. With the acquisition of Transics last February we now consolidate a full quarter of operating expenses from that business which added $9.7 million versus last year.

One thing to stress again is that Transics brings a different structure of cost into WABCO. Transics cost of sales are minimal in relation to WABCO's while Transics operating expenses from product development and selling make up the majority of their cost. The result is an overall profitability in line with WABCO's. Additionally, year-over-year operating expenses were favorably impacted by a higher incentive compensation accrual last year.

As Jacques mentioned earlier in the call, we continue to be negatively impacted from transactional foreign exchange effects, which amounted to $1.5 million in the quarter. We've seen relevant currency stabilizing and should they remain at these levels, we would anticipate a modest year-over-year impact in the coming quarters.

Our operating income for the quarter was $98.2 million or 13.4% of sales on a performance basis. It's worth noting, that at around 6% sales growth this result represents around 16% incremental margin which is consistent with our operational model.

Versus last year, equity income grew $0.5 million, driven by the strong North American growth that Jacques referenced moments ago. After a slight increase in our non-controlling interest expense, we delivered performance EBIT of around $100 million or a margin, up 13.7%.

Based upon the tax planning activities and the expected geographic distribution of profits, we are now adjusting the performance tax rate for the second quarter to 14% bringing the expected full-year performance tax rate to 14.5%.

After excluding the non-performance items, you can see that our earnings per share was $1.42 for the quarter an improvement of over 9% versus the same period a year ago and a new quarterly record for WABCO.

In summary, for this quarter WABCO delivered a solid level of organic sales growth supported by a high level of outperformance against our markets while continuing to generate profitability that is within the operational model, we commit to deliver on.

Let's now turn to chart 6 and I will take you through our cash flow for the second quarter. Working capital contracted by $15.6 million. Our days sales and payables outstanding have remained at good levels this quarter. We have also improved our inventory turns versus Q2 last year and we anticipate further improvements through the end of this year. In Q2, we invested around $28 million in capital purchases including spend-related to the expansion of our manufacturing capacity in Eastern Europe. The bulk of which will be finalized by Q3. This was offset by approximately $25 million depreciation and amortization.

Second quarter free cash flow was $88.8 million or $93.5 million when exclude streamlining separation and acquisition related payments for the quarter. The conversion rate of performance net income into free cash flow was 108% for the quarter which brings year-to-date to 73%. We are maintaining our commitment to covert 80% to 90% of our performance net income into free cash flow for the full-year.

And finally, we continue to return cash to our shareholders through the buyback program. We purchased nearly 1 million shares at a cost of $100 million this quarter. As of the end of Q2, we still have around $180 million left under our existing buyback authorization. For the time being we intend to keep returning cash flow back to our shareholders through the buyback program.

I would now like to turn it back over to Jacques, who will highlight the current market dynamics.

Jacques Esculier

Thank you, Prashanth. So returning to slide 7, will drive you through the updated forecast as we do every quarter around the different regions of the world. Starting with Europe, where registrations may year-to-date of heavy-duty trucks are up 7% versus last year. However production in the second quarter is down 6% versus a year ago and up 9% versus Q1.

Now for the 2014 full year we expect a level of registration of heavy-duty truck that region to be down 4%. And that leads actually to a revision of our forecast for production of truck and bus in Europe and we are downgraded our previous forecast of the ranch zero minus 5% to a range of minus 5 to minus 10.

Now kind of taking a step back and looking at framing 2013 and 2014 that have been heavily distributed by this pre-buy effect. When you look at actual production in 2013 and forecast production in 2014, worst as an average versus 2012, actually it's up 3%. So that means that since 2012, 2013, 2014 has been growing to 1.5% per year which I think is aligned with a fairly meager progress of the GDP environment. So, that minus 4% has to be seen a perspective of the pre-buy that happened in the last quarter of 2013. And at that time the forecast of 2014 level of production is also still 30% below the level that was reached back in 2008.

Moving to the U.S. Production is up 10% versus last year and 13% sequentially; altogether we're actually upgrading our forecast for this region from a plus seven to plus 12 range to a plus 10 to plus 15 with a gross plus eight that actually goes even beyond that. And even at that level we would end up 2014 production level 20% below the peak that was reached back in 2006.

Moving to China, production is eroding 6% year-over-year and 4% sequentially. We're actually at this point degrading the forecast as well for the full-year from a minus two to plus three range down to a flat to minus 5% with the first half of the year stronger than H2 and that's due to the fact that the implementation and enforcement of the new standard of emissions that was plan to take place in July 2014 was postponed to January 2014, so the bulk of the pre-buy happened in H1. And unfortunately there is not much pre-buy left to support H2 and that's what again we forecasted to be lower.

In India, market is down 2% year-over-year but still up 4% versus Q1. And we are upgrading our forecast from a plus five to plus 10 range to a range of plus 10 to plus 15. And again, we are right now anticipating a level of production of 2014 that would still be a strong 30% below the 370,000 trucks and buses that we have built back in 2011, so still a strong increase to go before we close that gap.

Moving to Japan and Korea on the following page, again, a much more stable environment, production up 3% year-over-year, 1% sequentially. Full year supposed to be flattish in Japan because of export canceling the impact of a stronger demand. Domestically still some growth in Korea. So, overall, for the full year we are actually upgrading our forecast from that minus 3 to zero range to a minus 2 to plus 3.

Then moving to Brazil. Very, again, kind of surprising and abrupt drop in Q2. It's due mainly to the fact that actually we added Q1 with a significant amount of finished goods in inventory that had to be burned during Q2, so it's not reflective of a demand that drop that much, but it's actually again compensating for the overproduction during Q1.

Actually for the full outlook we still think that we need to slightly degrade the forecast. We had a large range of minus 10 to minus 20. We now relate to minus 15% to minus 20% year-over-year. When you look at where 2014 would end up actually to put this in perspective, 2014 production would be 15% below what we have seen average between 2010 and 2013. And I remind you that the GDP right now is only forecasted to end up the year at 1.3 which is dramatically worse than what we have seen in the many years many previous years.

Going to aftermarket as I said we ended up with a strong 14 % growth year-over-year with a 10% contribution from the Transics acquisition. Our sales through normal channels have been infected by the conflicts in Eastern Europe and Middle East. As well as some inventory that were left over at the end of Q1 in Europe because of the very mild winter that we have seen that did not absorb the level of an volume of parts that normal winter do. Altogether for the full year, we still predict a growth of 15% including the contribution of Transics.

Then trailers mirroring very much the overall truck and bus world, about flat year-over-year sequentially driven by an increase in the U.S. by 6%, slightly erosion in EU by 2% and a strong drop in Brazil by 25% we still anticipate a market that will end up flat to plus 5% overall for the full year.

Then moving to the following page, kind of going through the achievements along the three pillars of our strategy. Starting with globalization, we won a first major contract with Transics outside of Europe and Saudi Arabia equipping a dairy company Almarai with a 1,300 systems for their truck and trailers so that obviously starts validating the synergies of putting Transics as part of the WABCO world. Than we added assembly lines in Brazil in our factory for ABS systems to support the demand over there, I’ll remind you that ABS is mandated now on all trucks and buses and trailers built over there.

We have opened a new Application Engineering Center in Pune, India to support mostly the TATA Engineering Center over there. Then in terms of technologies and products, we have unveiled the first modular braking system available in the market and that is very attractive to customers because it allows them to build trucks that are not differentiated whether they receive ABS or ABS systems and that's a very strong simplification in their supply chain.

We also expanded the TrailerGUARD technology to the waste management vehicles. That's allowing blind spot detection link to automatic braking. Then along execution we won a prestigious award for excellence in India. We also actually rounded off the year 2013 with a record 15 awards from our customers and industry players. And then finally as Prashanth have gone through it, we continue to provide a very strong productivity through gross material productivity as well as conversion productivity in our facilities.

Moving to the next page, I would like to share with you some changes that we brought to the top leadership team. It's fairly unusual for me to share that with you, but I thought it would kind of bring some additional color to the fact that WABCO is continuously adapting to what we anticipate the changes in transformation we anticipate from the industry and right now we see on the horizon accelerated globalization and because our customers are increasingly globalizing and reaching into all regions, it creates in our view a future intensifies competition among those OEMs, as well as a necessity to continuously integrate different products and systems of the trucks to seek for additional capability to increase efficiencies of those vehicles as well as the safety environment.

So to accompany WABCO along those lines and prepared to support those visions, we have created two divisions. The first one covers all business units delivering products and systems to the original equipment manufacturers manufacturing truck buses and a small automotive division that we still carry. And I've asked Leon Liu, who used to be the leader of our Asian business for the last 10 years to join and take the lead of this business.

I will remind you that Leon Liu was born in China, raised in China, got a PhD degree in engineering in Japan an MBA in the US, worked for Ford, Visteon and then joined WABCO 10 years ago and has really been the leader of the success that we know has been built in Asia by WABCO.

Bringing Leon to our headquarters will obviously built an additional bridge between the Western World and integrating the opportunities in the emerging markets. Nick Rens is taking the lead as President of the division covering Trailers, Aftermarket and Off-Highways. Nick has been working at WABCO for 25 years. In the later years, he has been leading aftermarket and trailer businesses that he has brought to very strong levels of growth and positioning the WABCO is the leader the strong leader in the trailer business and has generated significant growth in aftermarket. Nick Rens I want to remind you has been the leading executive in terms of acquisition of the Transics Company as well as this our dynamic business that we acquired last year.

Asides from those two divisions that cover the products, we keep and maintain those regional organizations namely one covering the Americas led by Nick Varty as President as well as the Asia-Pacific region comprising covering all the northern part of the continent led now by Sujie Yu who used to be under working for Leon Liu as the Head of China and Mr. Kaniappan who is taking over India and used to cover India under Leon Liu. And we also again welcome Prashanth who I'm sure will bring an enormous amount of value, best practices, new ideas to our company as we move forward.

So moving to the next slide, and looking at the guidance, we have actually tightened the guidance that we share with you last quarter on, particularly at the sales growth level we have decreased the upper level of the range from 11% to 9% reflecting the fact that we believe that the overall market for truck and buses may not be as favorable as what we had anticipated just a quarter ago.

I kind of want to remind you that just this morning we received a new report from IMF that predicts the overall GDP growth, global GDP growth to be down 0.3% at 3.4%. So that cannot be without an effect on the overall market for commercial vehicles, so that leads to the sales range of $2.925 billion to $3.015 billion.

Performance of margin in the range of 12.9 to 13.3 leading to a performance EPS of 545 to 575, which is now rode again taking into account a better bottom because we have seen favorable impact from taxes, from efforts on OpEx, on the OpEx front but we also take into account on the upper range a lower expectation of revenues and finally, not modifying our commitment to continue to deliver a strong conversion rate in cash flow.

The assumptions sustaining this guidance are unmodified except for the transactional effects amounts that we actually see favorably moving to $7 million whereas we thought it would actually be at $9 million a quarter ago and we’re also lowering our performance tax rate assumption to 14.5% as Prashanth shared with you before.

Then finally on summary, I would say that WABCO is kind of continuing to focus on delivering market outperformance in this complex environment. And we see market outperformance as the enriched view for what I would call our value machine. And the machine continues to work at transforming topline growth into bottom-line results using our incremental margin model, and for me, the second quarter of 2014 was an added proof of this.

Thank you and now I want to open the session for questions.

Question-and-Answer Session

Operator

(Operator Instructions).Our first question comes from Jerry Revich with Goldman Sachs. Your line is open.

Jerry Revich - Goldman Sachs

Hi, good morning and good afternoon. Can you gentlemen talk about on the wins you have had on the modular braking system platform? Are you the sole source braking system supplier in the regions you have outlined going forward? And is that across medium and heavy-duty platforms?

Jacques Esculier

Yes. For one customer, one of those key global customers we did in Europe, we have won a kind of unique position of single source of all their braking systems across the range, across the world. And obviously that modular platform was in our view very precious because it aligns with the desire for global customers to standardize as much as possible across the world and across their platform the type of modules that they implemented to their trucks and buses. And braking system is obviously one of them.

Jerry Revich - Goldman Sachs

And previously, Jacques is it fair to say you’re probably dual source on that supplier on that customer?

Jacques Esculier

Yes, we were. We were double sourced. The other win that we mentioned in the press release, is a win at another European customers but that would be actually to be introduced as a second source and that the customers where we never really had any you know strong position before. So that's also a breakthrough for us.

Jerry Revich - Goldman Sachs

And from a capital deployment sample and I think in your prepared remarks you spoke about using cash flow to buyback stock but clearly you're sitting with a pretty significant net cash balance just want to clarify because in the past you have spoken about moving to a net debt neutral position. And I would like to understand if that's changed and then maybe you could touch on just a longer-term tax rate outlook? You’ve done nice job of getting through the NOL ramps and just wondering if you talk about the implications from the tax rate going forward.

Prashanth Mahendra-Rajah

Sure. Let me take that Jerry. This is Prashanth. So first on, on your first question regarding our position on leverage. With the cash flow that this business generates we certainly have the ability to take on a substantial amount of debt. But as I think Jacques mentioned in the past we have seen a volatile market environment so we want to be very cautious that we always have the ability to keep ourselves well-positioned in ups as well as downs. So right now the plan is to continue to use the cash from the business to buy back shares, returned back to the shareholders as well as keep our eye out for acquisition opportunities, and at that point we may look at adding on some additional leverage to help with that.

Jerry Revich - Goldman Sachs

Okay. And the tax rate part of the question?

Prashanth Mahendra-Rajah

The tax rate part of the question. Sure. So we – I think, we started out the year with the guidance of about 16% on the tax rate. Today we’re lowering the guidance to 14.5%. Right now, that's a very sustainable rate for us.

I think we’ve talked in the past about making some adjustments to some deferred tax assets that we've had and we believe for the next several years we’ll be able to continue at this rate. Of course that will be impacted by our revenue growth and some of the jurisdictions which are higher tax. I think we’ve talked about that in the past being Brazil, the U.S. and particular. But otherwise our structure is very favorable and should allow us to maintain this level of tax rate.

Jerry Revich - Goldman Sachs

Thank you very much.

Operator

Our next question comes from Jeff Hammond with KeyBanc Capital Markets. Your line is open.

Jeffrey Hammond - KeyBanc Capital Markets

Hey, good morning, guys. Prashanth, welcome aboard.

Prashanth Mahendra-Rajah

Thank you, Jeff.

Jeffrey Hammond - KeyBanc Capital Markets

So, Prashanth I just wanted to get a better sense, on Europe are you seeing just the magnitude of pre-buy and overhang, is that kind of the issue are you more conservative or is it more some of these geopolitical issues that are really impacting demand in Russia and Eastern Europe?

Prashanth Mahendra-Rajah

Right now, Jeff, I have not been very hot on Europe along the years – along the last year's and in the last quarters that we had interfacing discussions on this continent. But -- and we haven't changed the picture of Western Europe. The only thing that as you said really kind of impacted our view of 2014 is what’s going on in the eastern part of our region and the impact it has on the overall market, both at the OE level and by the way at the aftermarket level as well. So otherwise you know that’s what I said. It’s kind of a flattish market. Year-over-year if you exclude that kind of swing created by the pre-buy. It's a meager 3% growth versus 2012 when you look at 2013 and 2014 together.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. And then just going to the incrementals and some of the moving pieces on SG&A, so I think historically you’ve been running kind of 4%, 4.5% on R&D and I think we ran 5.5, is there kind of some one time spend there or is there a reason why we should expect R&D higher and then if you could just kind of comment on, I think, you called out favorable OpEx of $4.2 million. What that was?

Jacques Esculier

Yes. Actually, Jeff, what happened in as we integrate Transics into our business, we have seen an increase in our gross margin because the Transics business model is actually not relying much on manufacturing, more on selling. You know software and equipment that is purchased from outside and at the end of the Transics model has more weight on the OpEx side than on the manufacturing side of the operation, so it resulted in an increase in our overall OpEx, in OpEx level.

Jeffrey Hammond - KeyBanc Capital Markets

Do they run at a very high level of R&D that would skew your R&D number?

Jacques Esculier

It's R&D it's also sales and all infrastructure their R&D is about $5 million a year.

Jeffrey Hammond - KeyBanc Capital Markets

Okay.

Jacques Esculier

$5 million – sorry -- $5 million for the quarter. That's about like $20 million a year.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. So it is pretty big and skews it.

Jacques Esculier

Yeah.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. And then the incrementals I guess you continue to have very good materials and conversion productivity and it just seems like the 16% incremental is a low given that transaction headwind is not as big of a deal and I guess your point that out, but help me understand why that incremental is a little bit lower here?

Jacques Esculier

Will actually -- it’s Jacques. Jeff is completely aligned with the model that we shared with you. Whereby we told you that between 3% and 5% we would be kind of flat in margin increase meaning that incremental would be around 13 point something percent we are at 5.9% and we delivered 16% incremental margins so in our own view we are actually more than delivering to the model that we shared with you.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. I see. Okay. Thanks, guys.

Jacques Esculier

Yeah, thanks, Jeff.

Operator

Our next question comes from Justin Long with Stephens. Your line is open.

Jacques Esculier

Good morning, Justin.

Justin Long - Stephens

Good morning.

Prashanth Mahendra-Rajah

Good morning, Justin.

Justin Long - Stephens

Going back to the European market, could you just talk about your general expectations over a longer-term timeframe, let say, over the next three years or so with production 30% below 2008 level, how do you see the recovery playing out and what’s the risk that we see some additional deterioration in this market?

Jacques Esculier

Overall, Justin, I would anticipate that we’re going to end up seeing some up trend, like we did in the U.S. The average age of the feed continues to increase. We think that for the last year's we have not really seen a production level that was supporting the GDP growth even.

When you look at the correlation between GDP growth and evolution of the volume of trucks, it's very much correlated, but it was not in the last year's reflecting the fact that in my opinion, fleets are very careful in investing. And that results, when you don't build new trucks that are needed to replace the old one it kind of – it results in the aging of the fleet that's exactly the profile that we have followed in the U.S.

And at one point when there is a lot more confidence in growth and people would tell you, you look at the, again IMS kind of production for the next year I think is 1.5% GDP growth is starting to kind of pull out of the majority that we have seen in the last couple of years.

So one could think that overall we would see is certain improvement that would allow the fleets to start investing more and kind of inverts the trend of aging like, again, we are seeing right now in the US. So I am not overly upbeat to be fair. I would be very cautious but I would say in my opinion even though we may see a further dip depending on the political situation that evolution of that situation in the coming months, but aside from this I would say we may see a further erosion but overall I would be a little bit more optimistic in the coming years.

Justin Long - Stephens

Great. That's very helpful. And you know as the second question I wanted to ask about localizing production in North America. I know that’s something you talked about recently. Could you discuss the key factors you're considering when you think about that invest and are there any update on that front in terms of where you stand on making that decision?

Jacques Esculier

Yes. We have to support a growing demand for products in North America. There are different factors that converge towards this decision. One is volume particularly related to vacuum pumps to the automotive sector, Chrysler and GM. There is ABS breaks that will increasingly be selected by fleets in our opinion. There is other systems that we right now manufacture in Asia, particularly in China, that may be actually at this point more financially attractive to manufacture in NAFTA probably in Mexico at this point. So all that stuff converges towards kind of establishing stronger larger grounds for us in NAFTA. And so where we are right now is probably kind of updating upgrading our operation in the Charleston area where we manufactured the bulk of the compressors we delivered to Cummins and seek for something in probably more in Mexico as well.

Justin Long - Stephens

Okay, great. I leave it at that. I appreciate the time.

Prashanth Mahendra-Rajah

Thank you.

Jacques Esculier

Thanks, Justin.

Operator: Our next question comes from Scott Group with Wolfe Research. Your line is open.

Prashanth Mahendra-Rajah

Good morning, Scott.

Scott Group - Wolfe Research

Good morning, guys. So just on a question about Europe and replacement, Jacques, you have some kind of numbers around where the age of the fleet is right now and when do you think we should start to see that replacement kick indeed, do you think it's next year or it could be another couple of years though?

Jacques Esculier

Well, we kind of believe the average age would be kind of 7.5, 7.6 right now which is a record in terms of level. You know and again I refer back to what we have said for a couple of years ago in the U.S., it was also record level for that region. And there is pressure because you see that new trucks are financially very attractive to wrong versus the older trucks in terms of fuel economy in terms of all kinds of efficiencies that go with it.

In terms of maintenance cost because in older truck that’s only burn more fuel it also cost more to maintain, and that was the logic that would prevail in a normal economical environment where whenever a truck would not be as economical to upgrade as a new one then people would switch.

And so that logic I think will come up again and take over versus the more conservative approach that we see at fleets today. That's again the – I think the natural evolution of things which in my own view by the way would prevent people from thinking that we are even close to reaching the top of the cycle.

Because to me when you see the U.S. level 20% below the peak, the European level 30% below the peak, I think there is still room for improvement in volumes, particularly as the overall GDP continues to grow, but maybe with some glitch in the U.S. this year but next year they plan again, 3%. So that's why I think there is room for some market growth ahead of us in both regions.

Scott Group - Wolfe Research

Okay. That's good color. Jacques, on the AMT side, just because we keep hearing from fleets, they like it. In terms of your OEM partners where do you see – where is your penetration right now? And what versus a year ago where do you think that can go and any potential progress or updates on some new partners there?

Jacques Esculier

Well, right now we are mostly supporting those manufacturers that are bringing their gearboxes from Europe. I'm talking about the U.S. market, right. And that's mostly Volvo and Daimler. And we have seen Volvo take a very strong stand at equipping and actually standardizing AMT as part of their trucks at least under the Volvo brand, which has resulted into a significant growth of volumes for us.

We believe that basically Daniel will follow the same path. So that's for the U.S. market and by the way Brazil. Now the AMT logic seems to also grow in emerging markets. We are seeing some very fast growing interest in India. We think that China will end up creating nice growth for us in that area. It has taken quite a while to be fair for all kinds of different reasons, but I think in the coming years we should see finally this technology kind of growing in penetration.

And then you hear things whether it's in Russia or in India again, you hear that markets are really pressuring OEs to find a solution to equip their trucks with AMTs. Not for growth large demand at this point, but in India right now we are starting with the buses, the city buses, that used to be equipped with automated transmissions that are switching now to AMTs because of the weight, of the price, of the flexibility in production. So I think it's going to probably gain and we are right now developing solutions for trucks as well. So I think increasingly we are going to volume growing there as well. So that's why for me this business should carry a lot of nice growth that will fit our performance channel for us.

Scott Group - Wolfe Research

That's great. And then just one last one for Prashanth and welcome. So I understood kind of your commentary around the cash flow, but I'm not taking on leverage yet but do you think that you are going to continue to buy back stock at a rate above free cash flow and even to some of the cash that just that part wasn't clear to me? And then didn't hear anything about dividend, is that something that you think you would be pushing for, Prashanth?

Prashanth Mahendra-Rajah

Thanks, Scott. So let me take a longer time. First recall that this year's buyback program was a special increase by the Board of Directors which reflected the reimbursement we got from the year if can find last year. So we will likely return in 2015 to more historical levels. And that would continue to be below the level of free cash flow generation but still a substantial commitment back to the shareholders.

And then in your second question was remind me -- dividends yes. So for right now I feel very good about the capital allocation policy for the company. That we're going to return cash to shareholders in the most tax efficient manner. And that would be through buybacks and we’ll continue to keep an eye out for acquisitions as you may know we have a pretty high bar here, so finding something that meets our requirements may be – may take us some time.

Scott Group - Wolfe Research

Okay. Thank you, guys.

Prashanth Mahendra-Rajah

Thank you.

Operator: Our next question comes from David Leiker with Baird. Your line is open.

Joe Vruwink - Baird

Good morning. This is Joe Vruwink on line for David.

Jacques Esculier

Hi, Joe. How are you?

Joe Vruwink - Baird

Good. Wanted to start on China and the strong out gross being seen here. You know is this coming from WABCO broadening the addressable market. So I think historically you had really targeted more of the kind of heavy-duty construction and of the market. So are you targeting new customers or is this new products that are broadening the market?

Jacques Esculier

Well, actually it’s a little bit of everything. First, we have seen lately a more favorable mix, meaning, more towards the heavy duty trucks that have more content for products and systems.

Second, we are gaining some shares at some customers. We have seen some increase in positioning of our ABS products for example at certain customers. Then we see more penetration of AMT that’s what I said before of air disc brakes, stability control, EBS systems as well. So, that’s all together for this quarter that resulted in that 26.5% of our performance section.

Joe Vruwink - Baird

And is that growth still predominantly with the local players like, CNHTC, or are you seeing the western customers with their local brands?

Jacques Esculier

You know actually in China, I would say we do business with most of the truck, bus and trailer manufacturers. I would obviously highlight CNHTC, FAW, Foton and then the truck and the buses manufacturer as major anchor points in that market. But we keep kind of growing our market reach and really improving and working at improving our business relationship with all of them including the smaller players. So, that’s obviously also a part of this outperformance.

Joe Vruwink - Baird

Okay. And North America, I just want to kind of better understand what seems to be a tipping point for fleets going into the ongoing product. You know AMT adoption has been visible for sometime with Volvo and it looks Daimler's going to follow soon. But with OnGuard it seems like it’s just really gaining traction right now. Is it just greater market awareness somewhere of like a marketing option from WABCO, because it seems like the economics have been there, the performance has been there, but it seems like results just keep getting better?

Jacques Esculier

Well, I think you know the value proposition for AMT for OnGuard as you said has been around for quite a few years, actually AMT even much longer than collision mitigation systems. But you know for each market, it takes a certain time. The market has to mature to the point where they recognize the value that you bring through these technologies. It’s everywhere the same way. And I think the turning point for the U.S. market has been this focus on pure economy that has obviously highlighted AMT as a very, very important option for them to do that as well as the shortage in drivers.

And the fact that you had to hire young drivers and train them with not much experience, AMT is a major element to shorten this training period and not actually allowing those less experience drivers to mishandle or abuse the mechanical systems, because the AMT will force to shift gear when the gear needs to be shifted. So it's just matter of recognizing the value proposition, have an alignment between the market demands and focus and the value proposition that you offer, right. And sometimes the alignment is not there, it takes time to grow and that what’s going on right now in the market.

Interestingly enough, the collision mitigation system which is a purely safety -- value proposition based purely on safety is not waiting for a standard or a mandate from the authorities, actually its going by self because the fleets recognize the compelling value proposition it brings and have already recognized that the level of accidents and incidents involving trucks equipped with those things is lower, nicely lower than if they are not equipped. So for me, that’s an interesting evolution that I look forward to seeing grow in other countries and may be in the emerging markets as well.

Joe Vruwink - Baird

Given the awareness about OnGuard and the fact that OnGuard it's a software solution, you really have to understand the entire truck echo system. Does that give you in roads into the fleet management offerings, so are you already out of the gates in running being able to integrate. I know it's not Transics in the U.S., but being able to integrate our fleet management like offering and essentially complementing the OnGuard solution?

Jacques Esculier

Well, as you know we have already announced a partnership with one of those FMS Company in the U.S. because we believe that indeed this collision mitigation system link to one of those systems that actually allow to monitor the driver, the outside world as well as inside the cabin, this we announce this mod drive relationship during the last quarter. And that's an element of value proposition that is also incredibly significant or attractive to fleet and that we would continue to grow particularly as we can at one point leverage our FMS solution transits that one way or another we would like to connect with the U.S. market.

Joe Vruwink - Baird

Okay. And then my last one is just on circling back to the engineering spend. Understand that fleet management requires more R&D dollars. Would there be any sort of customer reimbursements in the back half and kind of the “traditional web code business” that might bring the spending a bit lower in the second half?

Jacques Esculier

No. It's going to be running like it has been running in the past. They would still be reimbursements and we're going to still kind of maintain the relationship with key customers in that way.

Now to be fair, it has been the case for the last kind of four, five years, we have seen incrementally more engineering efforts both in our high class countries to support very high technology as well as emerging markets to further and faster adapt our technology to the specificity of those markets.

That level of activity has been rising, and still actually grows in importance. But to me supports the idea that we continue to outperform the market and maintain WABCO at the leading edge of technologies.

Joe Vruwink - Baird

Okay, great. I'll leave it there. Prashanth welcome aboard and look forward to working with you.

Prashanth Mahendra-Rajah

Thank you.

Operator

Our next question comes from Larry De Maria with William Blair. Your line is open.

Jacques Esculier

Hi, Larry.

Larry De Maria - William Blair

Okay. Thanks. Hi, everybody. Just following up on AMT. It's been a great story for WABCO, but can you help us frame maybe the side of the business on a consolidated basis? Help us understand the growth of that has occurred, with long-term maybe looking back 3 to 5 years and where we are now and some numbers specifically around the size of the business for AMT? And then secondly, how you see AMT evolving versus fully automatic. They have different duty cycles and tend to be competing at the moment in different market to some degree but how that battle may shape up. Thanks.

Jacques Esculier

Larry, we actually don't share this level of details at a product level because obviously competition would certainly love to know exactly where we are and whatnot. So what I can say is AMT is for me a vector of growth and outperformance in the coming years. Through the expansion of the channels that we see today and again that's still kind of grabbing some penetration in Europe but more importantly focusing in the US and in Brazil. And then kind of elevating the level of interest in sales to emerging markets, because we believe that AMT will become a very desirable technology in those markets.

Now related to Advanced Technology, to automated technology, you know in our own view and again that's WABCO’s view. There are some segments of the market where AT is better and segments where AMT is more desired and there's an intersection that we believe at that time gives us opportunities to transition some businesses that right now are more into the AT world and bring them to the AMT world.

Again by the simple fact that it's a lot less expensive, it's actually saving more fuel and it’s a lot less heavy. And it's more flexible for manufacturing their production mine because if they use the same gearboxes they use on manual transmission. Now what volume and whatnot this is again fairly sensitive information that you understand we cannot share with you at this point.

Larry De Maria - William Blair

Okay. I guess obviously they would argue in a lot of their duty cycles that they would have a better cost of ownership than AMT as well. Taken obviously quite apparent things like that and it sounds like if that's true do you maybe would agree or not agree with that, and based on what you said, are you saying that the battle is more in emerging markets versus fully automatic at this point and that converge overtime or is there obviously still some with the job in developed markets versus automatic as well?

Jacques Esculier

Well, again, it's a little bit complicated but I would say the bulk of the AT business is in the United States. We are in order for us to sell AMTs we need a gearbox, right. We sell AMTs on all the European gearboxes that are being bought to the United States. But we place a – to replace NAT, whatever manufacturer is using it at this point, we need an AMT on top of a gearbox and we don't have that kind of flexibility in the U.S.. That's something we have in emerging markets because whether at TATA or Ashok Leyland or those guys are when we equip – when we offer an AMT it's to equip their own manual gearboxes that now they will use in lieu of NAT. All right, so meaning that, obviously it's their platform at this time to again complete again the AT concept in emerging markets than in the U.S.

Larry De Maria - William Blair

Understood. That makes a lot of sense, thanks. And then there’s a second question. Specifically on the M&A pipeline, it sounds like the buyback stays at somewhere around relative to the historic levels beyond the current elevated authorization now into next year all else being equal, but what’s the specifically the M&A pipeline looking like now. Should we be expecting in terms of size and scope, how do we think about that? Thanks a lot and good luck this year.

Jacques Esculier

Good, Larry, well I would say, I keep kind of answering this question the same way. We have actually, I would say as compared to where we were two years ago before Nick already took that lead of that activity, we have a pipeline that's certainly richer in opportunities.

However I have not lowered my standards myself, meaning that we have more opportunities but we are still screening very much. You know, I would say we should expect to acquire company at a slow pace but maybe not as slow as what we have seen since 2007. But believe me we are still very, very demanding.

Larry De Maria - William Blair

Understood. Thanks very much.

Jacques Esculier

Okay, thanks, Larry.

Operator

Our next question comes from Alex Potter with Piper Jaffray. Your line is open.

Jacques Esculier

Good money, Alex.

Alex Potter - Piper Jaffray

Hi. How are you?

Jacques Esculier

Good.

Alex Potter - Piper Jaffray

I was wondering if you could, I guess, kind of revisit this long-term discussion. You did a nice job I think talking about U.S. and Europe in relation to historical peaks and where were at from a cyclicality standpoint. Can you do the same with Brazil? What you think looking three years out? Do you think that there is a chance that we could see kind of a sustained decline in this market or do you think this is something that will turnaround?

Jacques Esculier

Well, to me the old question is we see a GDP growth of 1.3% in 2014. Is it sustainable for Brazil or not. My own view, no, I think that there is a lot of logic pointing to a much better GDP growth. For Brazil, the problem it is has to be for Brazil as part of the global economy that increases. I think Brazil has been probably significantly hurt by the stagnation in some of the regions like the U.S. slowing down in China at one point. I'm not an economist unfortunately but I would say for me to believe that Brazil will stay at a very low GDP growth for the coming years, I don't think it's reasonable. You know so the level of trucks for me should come back. And you know like the same logic we had in India in the last two years where we have seen 40% drop in demand. And now it's kind of there's a certain rebalance of demand. I would expect something like this in Brazil, and again aside from the market evolution we keep driving our performance there as well. So for me there is still enormous amount of growth opportunities just beyond the pure increase in volume.

Alex Potter - Piper Jaffray

Okay, very good. And just the last question I had, you’ve spoken a lot about this globalization of platforms which I think is interesting and obviously the European OEMs like Volvo and Daimler are aggressive in taking their platforms global and their local they have a local presence in basically every market all around the world. Do you see the developing world OEMs the CNHTCs and FAWs of the world or maybe the Indian guys, do you see them with global aspirations as well, do you think their platforms will globalize? Thanks.

Jacques Esculier

Well, right now they are fully globalized because the only platforms they sell outside our platforms that are manufactured in their country. So it's exactly the duplication of the design they have in their home country. It's only if they would acquire other manufacturer that would obviously bring them new platforms like Daimler did in Japan in the U.S. and now in India. That would be for them the time to kind of reflect on the interest of globalizing modules or even platforms to drive the volume impact on productivity and cost because that's what's driving right now the Volvo and Daimler of this world than soon to be Volkswagen.

By kind of standardizing the modules and platforms you really leverage the volume and lower cost and become more competitive against local manufacturers or other local manufacturers that have not yet succeeded as much.

Alex Potter - Piper Jaffray

Okay. That's very interesting. Thanks a lot, guys.

Jacques Esculier

Thanks.

Prashanth Mahendra-Rajah

Thank you.

Operator

Our final question comes from Neil Frohnapple with Longbow Research. Your line is open.

Neil Frohnapple - Longbow Research

Hi, guys. Thanks for squeezing me in.

Jacques Esculier

Hi, Neil.

Neil Frohnapple - Longbow Research

Just a question on South America, you guys had nice 11% outperformance in that region in the first quarter with the full introduction of the ABS mandate. I'm just curious why the outperformance flow to 2% this quarter, if you guys could provide some more color on that that would be helpful. Thank you.

Jacques Esculier

Yes. Neil, actually its not that we have lost any market share. I just want to make sure that this is clear. But usually when you have those very sudden abrupt drop in production, you are talking about 17% quarter-over-quarter, immediately manufacturers OEMs stop buying parts because they have levels of in progress inventories that are higher than what they need to support the lower level production.

So that's usually very impactful on the revenues as well as obviously the outperformance. But the ABS outperformance is here. Meaning that results the help of our revenues from ABS we would have underperformed and again not surprising because you look historically when it happened to different regions of the world, we have usually underperformed, because people stop buying or by a lot less as they drop production.

Neil Frohnapple - Longbow Research

Great. That's helpful. Thank you very much, guys.

Jacques Esculier

Okay, thanks. Well, I think that’s the end of this call. So I wish you guys a good summer and will talk to you in October. Thank you.

Operator

Thank you, ladies and gentlemen. That does conclude today's conference. You may all disconnect and, everyone, have a great day.

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Source: WABCO Holdings Inc. (WBC) CEO Jacques Esculier on Q2 2014 Results - Earnings Call Transcript
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