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Tenneco Inc. (NYSE:TEN)

Q2 2014 Earnings Conference Call

July 28, 2014 09:00 AM ET

Executives

Linae Golla - Executive Director, IR

Gregg Sherrill - Chairman and CEO

Hari Nair - COO

Ken Trammell - CFO

Analysts

Brian Johnson - Barclays

Colin Langan - UBS

Richard Kwas - Wells Fargo Securities

Patrick Archambault - Goldman Sachs

Patrick Nolan - Deutsche Bank

Joe Spak - RBC Capital Markets

Brett Hoselton - KeyBanc

Ryan Brinkman - JPMorgan

Brian Sponheimer - Gabelli & Company

Richard Hilgert - Morningstar

Ravi Shanker - Morgan Stanley

Operator

Good morning and welcome to Tenneco's Second Quarter 2014 Earnings Release Conference Call. Today’s conference is being recorded, if you have any objections, you may disconnect at this time. Your lines have been placed on the listen-only mode until the question-and-answer segment of today’s call. Now, I would like to turn the call over to Ms. Linae Golla, Executive Director, Investor Relations. Thank you. You may begin.

Linae Golla

Welcome. This morning, we issued our earnings release and related financial information. Today, on our call Gregg Sherrill, Chairman and CEO; Hari Nair, our Chief Operating Officer; and Ken Trammell, our Chief Financial Officer, will take you through our quarterly results. The slides related to our prepared comments are available on the Investors section of our Web site at www.tenneco.com. We will then open up the call for questions.

Before we begin, I need to let you know that our discussion today will include information on non-GAAP financial measures, all of which are reconciled with GAAP measures in our press release attachment. The earnings release and attachments can also be found on our Web site.

In addition, some of our comments today will include forward-looking statements. Please keep in mind that our actual results could differ materially from those projected in any of our forward-looking statements. With that, I will turn the call over to Gregg.

Gregg Sherrill

Thank you, Linae, and good morning everyone. Today, I am pleased to report that we delivered another excellent quarter with record high results for revenue, EBIT, adjusted net income and earnings per share, all contributing to a strong first half of the year. It’s evident by our performance that we are executing well on the strategic imperatives for both product lines which are driving revenue growth and improved profitability. Balance across products, end markets, regions and platforms is a Tenneco’s strength and that balance was once again reflected in this quarter’s results.

Revenue increased in both Clean Air and Ride Performance and in most of the geographic segments within each product line. If you look at end-markets, revenue also increased in our light vehicle, commercial truck and off-highway and global aftermarket businesses. All of this growth contributed to a total revenue of $2.2 billion, our highest ever for a quarter. Taking a closer look at revenue on Slide 3, you can see that we successfully capitalized on the stronger light vehicle production environment with our outstanding global customer base and divers platform mix.

Our total OE light vehicle revenue increased 6%. Our commercial truck and off-highway business also showed strong growth in the second quarter with revenue increasing 27% to $302 million which included increases in all reporting segments. The growth was driven by new content and higher volumes on programs in Europe, North America and China. Our commercial truck and off-highway customer list on Slide 4, has expanded substantially. In fact five years ago, we were producing for just five of the customers on this list whereas by the end of the year we will be supplying all of them. This is the testament to the success of our strategic approach of aligning our products and capabilities with the regulatory timeline.

This global regulatory expertise is critical to anticipating and being ready when our customer need us with solutions to meet increasingly strengthened emission standards globally. And on Slide 5, we have extended the timeline through 2019 which shows how these regulatory drivers continue to evolve and will fuel our Clean Air growth well into the future. Rounding out the end-markets, revenue also increased in our global aftermarket business which grew 4% on the strength of the Ride Performance business in North America and South America where Tenneco remains the market leader in both regions.

Turning to earnings on Slide 6, both product divisions increased earnings this quarter, contributing to our highest ever adjusted EBIT of $166 million, a 12% increase over last year. Overall, our EBIT performance improved on higher light vehicle volumes in Clean Air and Ride Performance and increase in Clean Air commercial truck and off-highway revenue, higher global aftermarket sales and cost savings from our Ride Performance product cost leadership initiatives. We improved our profitability this quarter with value added adjusted EBIT margin increasing 20 basis points to 9.6%. Our two product divisions together are driving profitable growth as we implement distinct strategies for each. These strategies include investing in technology and capabilities to develop cost effective solutions while continuing to drive operational excellence.

Our results today reflect the effort of an exceptional global team that never losses side of our commitment to provide our customers with proven technology solutions, the highest quality product and outstanding service. Each quarter we continue to win business stay focused on launching new platforms and consistently delivering on current programs. I thank our employees for putting us on the path towards achieving a successful year.

And with that I’ll turn it over to Hari.

Hari Nair

Thanks Greg. Beginning with Clean Air on slide eight, total worldwide value-add revenue was up 12% to reach $1 billion for the first time in a single quarter with every geographic segment reporting higher revenue. In North America Clean Air value-add revenue rose 13% driven by our strong platform position on new and existing models including recently launched programs such as the Jeep Cherokee and the Corvette with Tenneco’s electronic valve. In addition to light vehicle, the continued phasing of new content for Tier 4 final regulations contributed to higher off-highway revenue with both Caterpillar and John Deer.

Taking a look at the Clean Air Europe, South America and India segment, value-add revenue rose 5%. The positive drivers this quarter included higher production in Europe on strong selling light vehicle platforms with Daimler and Volkswagen as well as continued growth from several recently launched programs for Jaguar and Land Rover. Higher commercial truck and off-highway revenue also contributed to the Clean Air increase with higher volumes and incremental content on programs with Scania, Caterpillar and Deutsche in Europe. Similar to last quarter revenue growth in Europe was partially offset by weak economic conditions and lower light and commercial vehicle production in South America.

In the Asia-Pacific, Clean Air segment we delivered another strong quarter with 21% higher value-add revenue versus last year with China driving the segment results. Light vehicle revenue growth significantly outpaced overall vehicle production as we benefited from strong volumes on existing programs and the ramp up of new platforms. Higher commercial vehicle revenue also contributed to our growth as orders from commercial truck customers in China continue to increase.

Now looking at Clean Air EBIT on slide nine, adjusted EBIT increased 9% to $120 million. The improvement was driven by good operational performance on higher light vehicle volumes primarily North America and China and the benefit from higher commercial truck and off-highway revenue in North America, China and Europe. These drivers were partially offset by a very weak production environment for light and commercial vehicles in South America. Clean Air value added adjusted EBIT margin for the quarter was 11.7% reflecting strong light vehicle and commercial truck and off-highway volumes and $7 million in higher engineering expense in the quarter. As we’ve mentioned before, the timing of our engineering spending and recoveries can vary quarterly but are consistent as a percent of revenue on an annual basis.

Now let’s turn to Ride Performance starting on slide 11. For the second quarter, global Ride Performance revenue increased 6%. In North America, revenue was up 12%. The strong overall light vehicle production environment, the benefit from recently launched content on new light vehicle programs, higher commercial truck revenue and strong after market performance all contributed to the increase. The Europe, South America and India segment revenue was roughly flat for the quarter. OE revenue in Europe was up but the increase was offset by lower volumes in South America.

In the Asia-Pacific Ride Performance segment higher revenues in China were offset by lower volumes in the rest of the region.

Turning now to Ride Performance EBIT on slide 12. Ride Performance adjusted EBIT increased 29% to $75 million with all reporting segments improving versus last year. The main drivers were higher revenue in light vehicle and commercial truck business in North America, cost savings related to our global product cost leadership initiative and the benefit of strong after-market sales in North and South America. Ride Performance adjusted EBIT margin rose to 10.7% in the second quarter.

Before turning it over to Ken let me give you a brief update on the progress of our European cost reduction activities. In Sint-Truiden in Belgium and Gijon, Spain; we finalized agreements related to our restructuring at those Ride Performance facilities. Overall, we remain on track with our goals for the Europe cost reduction initiative we first announced early last year which will help improve our long term competitiveness in this important market.

In summary, both of our product divisions performed well in the quarter and we continue to do a good job balancing two basic operational success factors, managing costs on a daily basis and investing to support future growth. I want to thank our entire global team for their efforts. Tenneco employees share a strong focus on executing our strategies to drive profitable growth and a passion for continuously improving our operational performance. Through disciplined use of the Tenneco manufacturing system, Six Sigma and lean manufacturing initiatives, we identified new opportunities to improve quality, reduce cost, eliminate waste and satisfy our customers, all of which help build sustainable success for Tenneco. And now I will turn the call over to Ken.

Ken Trammell

Thanks, Hari. Turning now to Slide 13, in the quarter, we recorded an additional $4 million of restructuring and related cost in Europe, $3 million for projects in our Ride Performance business and the remainder in Clean Air. To-date for this initiative, we recorded $94 million, out of the total expected cost of $120 million. This quarter we realized savings of $8 million related to these projects. Also in the quarter, we recorded $5 million of restructuring expense in Australia, primarily related to headcount reductions, as our OE customers continue to reduce production levels. Finally, we incurred $1 million of restructuring cost in South America Ride Performance to reduce headcount in that region.

Before we discuss taxes, I will touch on selling, general and administrative expense. Adjusted SG&A was $136 million or 6.1% of revenue in the second quarter which is in line with our full year expectations. Legal costs related to the anti-trust investigation were $5 million in the quarter. Moving on the tax and interest expense on Slide 14. Tax expense in the second quarter was $46 million. Before the adjustments, our effective tax rate was 33% in the quarter and 35% year-to-date. In the quarter, the tax rate benefited from improved results in countries where we cannot record a tax benefit as well as earnings growth in lower tax rate jurisdictions such as China, Poland and the Czech Republic. Based on these factors, we currently expect the 2014 full year effective tax rate before adjustments will be about 36% at the lower end of the 36% to 38% range we gave earlier this year. Interest expense in the second quarter was $19 million which is $1 million lower than last year.

Now let’s go over to cash flow on Slide 15. In the second quarter, we generated $114 million in cash from operations compared with $133 million in cash from operations a year ago. The change versus last year was driven by working capital investments for growth. Overall, our working capital metrics were in line with last year. Days sales outstanding excluding factoring increased two days from last year to 62 days and inventory days on-hand was 37 days, also a two day increase from a year ago.

Day’s payable outstanding at quarter end improved four days to 73 days for a net change of zero days in our working capital metrics. Capital spending in the second quarter was $83 million. The increase compared to last year which primarily due to timing during the year of our capital spending and higher investments to support Clean Air programs in China, North America and Europe. We are expecting capital expenditures for the full year to be around $300 million.

Turning to Slide 16, in the third quarter, we expect to launch a voluntary program offering to buyout former employees in the U.S. pension plan. We expect to complete the process in the fourth quarter and take a non-cash charge at that time.

The cash payments to those who elect to take the buyout will be made from the pension plan assets, so this program will not impact Tenneco’s cash flow. While we won’t know how many former employees will expect the offer until it closes in the fourth quarter, we have been told that the average participation rate in similar situations has been about 50%. At that participation level the accounting charge would be $17 million.

Now turning to debt on Slide 17, at quarter end debt net of cash balances was $1.32 billion, down slightly from the quarter end balance a year ago. Our leverage ratio improved on increased earnings to 1.4 times compared with 1.6 times a year ago.

And with that I will turn the call back to Gregg.

Gregg Sherrill

Thank you, Ken. In summary, we delivered an excellent quarter that keeps Tenneco on track for a successful year with bigger drivers fueling our growth. These drivers have been consistent through the first half of the year and we see no changes in the third quarter. As you can see on Slide 18, global light vehicle production is forecasted to increase 5%. We expect to capitalize on this production environment with our strong mix of customers and platforms to generate an increase in light vehicle revenue in line with the 5% industry rise. We anticipate a significant year-over-year increase in commercial truck and off-highway revenue in the third quarter, driver by new content and stronger volumes in China.

We expect revenue to increase between 20% and 25% in the third quarter and that’s against a strong third quarter last year. We should see a steady performance from our global aftermarket business in the third quarter. The after-market is a strong part of Tenneco’s balance equation providing a countercyclical business to the original equipment markets as we saw in South America this quarter.

On the Ride Performance side, we are a market leader and continue to generate good results on the strength of our brands, product coverage and distribution capabilities. In closing, we delivered excellent revenue growth in earnings in the first half of the year and are well positioned for the second half. We have the right strategies to help each product line to reach its full potential. Growth drivers in our Clean Air business continue to create tremendous opportunities for Tenneco and we’re seeing cost savings in Ride Performance as we implement our global product cost initiatives strategy. We are balanced across our operations and have a solid foundation of shared values, operational excellence and financial strength. With this foundation and opportunity in both businesses we’re staying focused on consistent execution to deliver more success for our customers, more value for our shareholders and a bright future for Tenneco.

Thank you for joining us this morning. And we can now open the call for questions.

Question-And-Answer Session

Operator

(Operator Instructions) The first question today is from Brian Johnson. And please state your company name.

Brian Johnson - Barclays

Brian Johnson from Barclays. Thank you. A couple housekeeping questions and a strategic question. On housekeeping, within the emissions control division, it seemed like there were a number of puts and takes in the business. So we had very good three-quarter ton pickup volume. You had some engineering cost headwinds. I guess a couple things. Would profits have been stronger, was there something kind of weighing against the good results out of China and likely North American diesel, like European diesel mix that were a headwind there? And then second, those engineering costs, do those get recovered in later quarters or is this just an investment that you are making on your nickel?

Gregg Sherrill

So on engineering cost Brian there is always timing of cost and recoveries. Yes, we do recover our engineering. Some of it is recovering from customers in terms of payments for preproduction engineering but a good bit of it works much like our light vehicle does where it’s recovered over-time in other words in the piece price. So that is obviously eventually recovered. But we did have a timing amount in terms of spending in recovery when you compare quarter-over-quarter.

On the margins, again kind of going back to the engineering Brain if you just sort of look at that and say hey that’s a timing difference and if you normalize for that the Clean Air margins would have been up instead of down in the quarter, so that’s the primary driver there and that’s I think quite Hari pointed out in his part of the presentation.

Brian Johnson - Barclays

Okay, and also going forward, do you see, when you look at China CV, that there is finally getting traction in enforcement of some of the more stringent emissions control? And as you kind of think about that 20% to 25% guide, is that one of the positive factors and at the same time, would you look at the global ag markets, North American ag market and see those perhaps growing more slowly than we thought at the beginning of the year?

Gregg Sherrill

Yes, China is positive in the number as you just suggested, there is no question about that. And traction, I do think we’re getting some traction in China as we said I think in previous quarter’s this year it may it’s not going to be a rocket ship over there and there may be somewhat of a not leveling but a slower in the rate of growth for the back half of the year but then increasing again next year that’s kind of what we’re seeing again right now but definitely traction, definitely positive, definitively upward movement. And it’s going to be a positive contributor to us for the rest of the year as we see it right now.

Ag is a little bit down, I mean it’s out there in the market you know that and South America is definitely down in commercial vehicles. So those are probably the sort of the negative side but everything else is very positive. The content launches are going well. We’re growing in Tier 4 final and four-b in Europe right now with content. So, obviously, the positive drivers were offsetting the puts and takes with some of the regional issues and market issues that are maybe there with South America and ag. So all in all we’re feeling good about it right now.

Brian Johnson - Barclays

Okay, thanks.

Operator

Thank you. The next question is from Colin Langan and please state your company name.

Colin Langan - UBS

Great, Colin Langan, UBS. Thanks for taking my question. Can you give any color on the North American Ride Performance? It was up 12%, which seems like a pretty substantial outperformance. How was that relative to the OE and the aftermarket and what were sort of the main factors in that substantial outperformance to the market?

Gregg Sherrill

Colin, it’s really both. The after-market Ride Performance business had a good quarter. This is seasonally strong this quarter so we’re certainly happy to see that happen. But the OE was strong as well and as Hari pointed out in his comments that we saw some strength in commercial truck in the quarter. Now I will remind you that we have commercial business commercial truck business on both the Ride Performance and Clean Air side but in North America it is really a Ride Performance side because it going to get a little bit of as start business on the Clean Air commercial truck side in North America, so what you’ve seen with sort of strengthened commercial truck business is what shown in the revenues. And then again, good platform mix in this quarter for the Ride Performance business and light vehicle size as well.

Colin Langan - UBS

Okay. And on the pension offer, I mean any color on the size of the amount of the PBO that the offer is being given to because I think you had mentioned just salaried workers, if I am not mistaken. When this offer comes out, is there no change to the funding status of the plan or will it be a slight change?

Gregg Sherrill

So the offer will go to terminated employees, so obviously just people we work for Tenneco in the past who invested in that pension plan that was frozen back into 2006, so it’s been quite awhile since anybody has earned any new benefits in that plan. That 50% participation level, that 17 million counting charge would roughly equate to somewhere between $35 million and $40 million of cash payments from the pension plan, the pension plan itself is probably funded a little over 90%. So there will be a small change in the net liability position of the plan, but it won’t be significant.

Colin Langan - UBS

Okay. And any color on the -- I mean it's not the whole PBO that is getting the offer though, right? It is only a part of it?

Gregg Sherrill

Like I said, it is people who are terminated, invested; and remember I said about $35 million to $40 million of cash and that’s probably in the neighbor of only 10% of the assets that are in the plan.

Colin Langan - UBS

Okay. And then just one last question. Any thoughts -- I mean your leverage seems to be improving. I mean where do you stand today in terms of deleveraging versus using cash for M&A? Obviously, that is something that's coming up in the sector right now or repurchases?

Gregg Sherrill

Yes, probably, we have been clear, right. Our target is onetime leverage ratio from in terms of what we’re doing for the benefit of the Company to make sure that we’re in the good shape. The next time, there is a cyclical downturn in the business and our priority just stayed the same. Investments for growth, we’re obviously number one. Our European cost reduction plans are number two and as Hari pointed out, we’ve reached agreements on a couple of those particular actions here last second quarter, late-late second quarter or third quarter, so the cash selection will be spent in the third and fourth quarter for a lot of those actions.

But that those European cost reduction plans are our second priority because that’s a pretty good return investment. Balance sheet is number three, ride into get to the onetime we’re going to continue to work on both our debt positions as well as the pension liability. Any strategic investments will be fourth win and this gets this to the capital deployment. The one time’s leverage ratio is something we need to achieve.

I want to remind you that we do have a seasonal leverage ratio that loose much like the cash flow the business does and tends to go up in the first half and back down in the second half and so we would certainly want look for something to that puts the Company in a strong position related to our debt covenants in event there is another downturn at sometime in the future before we would get there. Nevertheless, the fact that we’re talking is I think a good indication of we’re getting closer certainly than we better in the past.

Operator

Thank you, the next question is from Richard Kwas. And please state your company name.

Richard Kwas - Wells Fargo Securities

Hi, good morning. Wells Fargo Securities. Just on Q3 guidance in terms of the revenues, how much impact -- you had good mix in Q2. How much of a hit or less favorable mix have you factored into the light vehicle revenue guidance here for Q3?

Gregg Sherrill

On a global basis, as you think about Rich, we generally grow a little bit faster than the OE production level. And what Gregg pointed out in his presentation is that in the third quarter, we expect to be about the same as the production level, so obviously mix is a little bit less favorable for us than it tends to be overtime. Obviously, some big platform changeovers are moving into more in the fourth quarter than in the third quarter, but little bit impact in the third quarter and so that’s what takes us to that guidance. So if you know roughly in line with that 5% sort of global increase and production in those regions where we do business.

Richard Kwas - Wells Fargo Securities

Okay, so the way to think about it is some of the pickup truck with Ford and whatnot that is going to be less favorable toward the end of the quarter and less favorable into Q4 until they get ramped up and that is how you are planning for this?

Gregg Sherrill

Yes, that’s right, absolutely.

Richard Kwas - Wells Fargo Securities

Okay. And then in terms of the full-year CV revenue guidance, are you still targeting 20 to 30?

Gregg Sherrill

Absolutely.

Ken Trammell

We think we’re right in that universe for sure.

Richard Kwas - Wells Fargo Securities

Okay. Because it seems like based on the guide for Q3 that would imply at the midpoint you should be somewhere around the midpoint for the year just doing the math here. So just wanted to confirm that. And then just CapEx, it looks like it is trending a little bit higher, Ken. In terms of working capital, it was neutral, but I mean is there any potential -- I know there is opportunity, but if you think about the near term over the next couple quarters, do you think working capital can offset some of the CapEx creep?

Ken Trammell

Sure, CapEx is still in the range that we gave. We gave 275 to 300 and we’ve said that we are probably right around that 300 level. So we’re still sort of in the range. Working capital obviously as always will certainly work in that especially inventory that was up a couple of days in the quarter and we’ll be seeking to get that back by the time we get to the end of the year.

Richard Kwas - Wells Fargo Securities

Okay. And last one, on the costs for the investigation, is that still going to run $3 million to $5 million for the back half?

Ken Trammell

Yes, I think what we said; Rich, on the call last time was it would be $3 million to $5 million for two to three quarters, so on into the third or probably the fourth quarter depending on the timing of resolution. And after that there is a point we would see it start to trend down a little bit but we were $5 million this quarter, expected to be sort of in that same range for the next couple of quarters.

Operator

Thank you. The next question is from Patrick Archambault and please state your company name.

Patrick Archambault - Goldman Sachs

Yes, good morning, from Goldman Sachs. So you guys had -- for the first half, margins have been up year on year on an operating basis. I am just looking at all-in obviously, but I think on value-add, it's the same. You did this despite some pretty meaningful headwinds in terms of the legal fees, as well as the engineering investment. So given the growth outlook is still quite good for the second half obviously, not as -- not outperforming the light vehicle side as much, but still in sum pretty good, can we expect that trend to continue from a year-on-year standpoint?

Ken Trammell

Year-on-year on the overall margins, yes I think we are still there that it should continue. Again, we have said we are not going to ensure you that we will hit it every single quarter even though I think we have managed to do that so far because there are some puts and takes that go on quarter-to-quarter and timing and spending and all that sort of thing. But the overall trajectory certainly on an annualized basis, we feel like is for continued improvements there.

Patrick Archambault - Goldman Sachs

Okay, terrific. And then my second question was just on the slide 5, the regulatory outlook, it's nice to have that detail updated. I was just wondering -- I know you tend to give the longer-term guidance at year-end when you report or early next year when you report fourth quarter, but I guess just having gone through this exercise in some detail, how are you thinking about your OE revenue CAGR of 10% for five years that you originally put out? Interesting to see some locomotive and marine stuff here that may not have been part of that original growth outlook. So just your perspective on there.

Gregg Sherrill

I do think it probably was a part of our original growth outlook, remember we are looking out even internally beyond the 2019 as we plan and work with regulatory agencies and try to understand exactly where they are headed. And then we just give you this rolling chart every year which we just updated now out through 2019, so we don’t see any real surprises in there, always see a confirmation of our strategy and that that growth outlook is still very, very positive and 29 teams add just confirms that I think so.

Operator

Thank you. Our next question is from Patrick Nolan and please state your company name.

Patrick Nolan - Deutsche Bank

Hi, it's Deutsche Bank. Good morning, everyone. Most of my questions have been answered, so I just had a couple of modeling follow-ups. On a value-added basis, the gross margin performance in the quarter was actually quite strong. On our numbers, it looks like the incremental was in the high 30s. Typically you guys do anywhere from kind of low to high 20s. Was that all just a factor of the mix in the quarter and we shouldn't think that's sustainable?

Ken Trammell

I think you saw certainly improvements on Clean Air side but you have also seen both I think Gregg and Hari pointed out in their presentations strong performance from our product cost leadership efforts on the Ride Performance side as well. I think we have said for the last several quarters really since we rolled out our new strategic imperatives in the beginning of 2013 that near-term there is as much opportunity on the Ride Performance side just from product cost leadership as there is from growth on the Clean Air side and I think that’s what you are seeing come through there.

Patrick Nolan - Deutsche Bank

That's helpful. And just a quick one on the SG&A. It seems to be moving up a bit as a percent of sales, is trending kind of the high 5% of sales. At the end of last year, it has been running in the high 6%s year to date. What should we be thinking about that going forward?

Ken Trammell

There is always timing right, I want to point out that the quarterly results obviously I want to remind you, includes the $5 million of incremental legal cost and that’s about 0.1% of our revenue in the quarter. So, if you take that out, it’s down just a bit from what obviously the reported number is but because of timing of cost and accruals, things like performance based compensation, stock index compensation, aftermarket promotion, quarterly remember Patrick, it can vary. And we said I think several times that we really need to look at over, like a, 12 months period, so if I look at where we have been and I am just going to give you an example over probably the last 10 quarters, our last 12 months SG&A as a percent has ranged between 5.6% and 5.9% and we are 5.9% in the quarter.

So, sort of taking out the timing impacts we are sort of in that same zip code that we have performed at for probably the last two to three years.

Operator

Thank you. The next question is from Joe Spak and please state your company name.

Joe Spak - RBC Capital Markets

So just one I guess point of detail on the $7 million engineering, if we look at Clean Air regionally, North America, Europe a little bit down, is that because that $7 million, it was for Tier 4 final and if so, now that we have had a couple quarters of that, should that subside a little bit in the back half of the year?

Gregg Sherrill

Joe, our engineering spending sort of runs to gain it between what we’re working on currently like you said think of our Tier 4 final and what we’re working on three to five years out. So again if you sort of look at over similar to what I just said about SG&A if you look at engineering over a more extended period of time as a percent of revenues we’ve been right around 1.8% to 1.9% which is where we are this quarter on an LTM basis. So, it normalizes over time than it has to do with timing of both spending and recoveries.

So both of those items as Ken just said if you look at it on an annualized basis and there is a lot of timing things that we don’t control engineering has its own set of issues with timing of recoveries, et cetera and timing of spend quarter to quarter depending on timing of the out program so we’re working on. But we have been very consistent year end and year out at holding that in those ranges as Ken just stated and we’d anticipate that to continue.

Joe Spak - RBC Capital Markets

Okay. And then if we look at the restructuring and the ride control performance, it looks like, on an annualized basis, that restructuring, you are sort of halfway to your eventual target, which I think is on schedule with what you guys have said previously. And you did -- I think most of the restructuring is towards ride control. You did over 10% this quarter. Even if we look on a trailing 12 months, you are sort of at about 9%. I mean is the right way to think about this business as we think further out that this is a sustainable double-digit business once the restructuring is fully in the model?

Gregg Sherrill

So great question obviously as we work on the opportunities in the Ride Performance side we’ve seen really strong improvement in margins and we do believe there is more opportunity there. We make a lot of shots and struts roughly in the neighborhood of 90 million shot conventional shots and struts last year. Again we leverage what we’re working on across all of those businesses there is opportunity now I can’t tell you what happens in the future certainly there is opportunity there and we’ll look at headwinds as well but we certainly think we’re not done yet with improving the margins on the Ride Performance side.

Ken Trammell

All that efforts that’s going into the cost initiative we do believe that that part of the performance improvement is sustainable and we’re going to keep it and its there. Don’t forget that there is also particularly on the Ride Performance side one mix element that would be beyond our control and that’s the after-market versus the OE sales because Ride Performance is really to workhorse of our aftermarket business and this quarter, for example it’s quite strong in North America and South America now brands that weaker in Europe but those types of macro market mixes can also get in there as we go forward just to kind of watch out for.

Joe Spak - RBC Capital Markets

Okay. And Ken, a quick housekeeping on the pension. If you assume that 50% take rate [Indiscernible] that you mentioned, is there any meaningful impact to interest costs or anything?

Ken Trammell

No. again, the cat flow will be paid by the pension plan not by Tenneco. So it’ll be no impact on our debt levels.

Joe Spak - RBC Capital Markets

And on the expense?

Ken Trammell

Again the pension plan is a little over 90% funded so there is probably at the margin some very small changes but it’s not going to be a significant impact on the plan, it’s only 10% of the plan assets.

Operator

Thank you. The next question is from Brett Hoselton and please state your company name.

Brett Hoselton - KeyBanc

Good morning. Just wanted to kind of run through the margin headwinds and tailwinds in the quarter just to make sure I understand them. It sounds like you had a restructuring tailwind of about $8 million, an engineering headwind of about $7 million and an antitrust legal headwind of about $5 million in the quarter. Those seem to be the three major buckets that you've identified. Is that a fair assessment?

Gregg Sherrill

Yeah, it’s actually that’s what we said Brett.

Brett Hoselton - KeyBanc

Okay. So if I make some adjustments to some of those numbers in my quarterly number and I look at the contribution margin for the overall Company, not just the value-added but everything, the whole enchilada, I get about a 14% contribution margin. And that compares to a 14.7% contribution margin in the first quarter, and then it dials down to 11.7% in the fourth quarter and 8.9% in the third quarter. It seems like your margins are improving quite nicely. You have got a nice tailwind. I am wondering as you look out into the second quarter -- or excuse me, into the second half, into the third and fourth quarter, do you see any particular headwinds or tailwinds incremental to what you've currently seen that might cause that contribution margin maybe slow down, be tempered a little bit, or maybe even accelerate?

Gregg Sherrill

Brett I think we’ve sort of talk about all of the puts and takes on a go forward basis legal costs are expected to continue here for another couple of quarters. So I wouldn’t assume that those go away. We’ve also talked about the timing of engineering recoveries and those will tend to level out over a 12-month period just be different up and down on a quarterly basis. Do you want to point out on that when Gregg talked about the outlook for the third quarter that our growth rate for our OE light vehicle business will be more in line with what the production is and almost quarters if you talk about we generally outgrew, we talk about the reasons why that is. So obviously that’s going to be -- volume will still grow but it won’t grow at the same rate that has in the past simply because of the mix. So there is going to be puts and takes. Again, I want to go come back to what kind of what we said, incremental margins will vary both up and down from a quarterly basis. We don’t have a guidance number to you give, but there certainly will be quarters when they’re very strong and quarters when they’re quite strong just because of timing of the what happens in front of the business.

Brett Hoselton - KeyBanc

And then as far as the growth rate as we look into the third quarter, as I think about the aftermarket business year to date through the first six months, you are growing at a rate of I think 3.4% if I did my math correctly. And so kind of flat into the third quarter. It seems just like it's a reasonable expectation but possibly on the conservative side. Is that a fair assessment, or are you looking at the aftermarket business thinking on a year-over-year basis, it is going to slow down in the third quarter for this reason?

Gregg Sherrill

I think, Brett, what we factor in obviously is what’s happening from a regional perspective. We saw a good performance in North American aftermarket here in the second quarter. We did see some weakness in Europe. South America, down only side that’s what we’ve always said tends to be kind of cyclical and so that’s helped us hold up what’s going in the South America side of the aftermarket. And our expectations just based on what the expectations for the industry is and what we think that translates into for our particular market shares.

Operator

Thank you. The next question is from Ryan Brinkman. And please state your company name.

Ryan Brinkman - JPMorgan

Hi, from JPMorgan. Good morning. A lot of good questions have already been asked. I would just ask what you’re thinking here is in regards to M&A. You sort of answered that earlier as it relates to leverage, but maybe as it relates to technology. I'm just curious on the Clean Air side. Do you see yourself more as a Clean Air company, more of an emission control company or more of an aftermarket company? Are there technologies that impact emissions apart from that treatment you might consider, for example, evaporative emissions or something else under the hood?

Gregg Sherrill

What we see ourselves that we try to be as clear as we could about that is a clear air company with our main product technologies and our more markets being reciprocating engines if you will, okay, that’s where our technologies work. Whatever markets you put diesel or gasoline or natural gas part of biodiesel or any of that into our reciprocating engine, we have the technologies and we continue to work on those technologies to consider those markets as they come into regulation around the world. We have not set that we would participate in every single market. Some of them might not fit our idea of sort of being a manufacturing company. Some of them are -- especially if you get out into the really big engines and you get into what you refer to aftermarket I would refer maybe as retrofit, there more of a project base business. We would evaluate it. But certainly, if we didn’t see that was the right fit for us we wouldn’t get in. The opportunities are great right down our wheelhouse of manufacturing components for and systems for any of reciprocating engine applications within certain ranges. That’s what we ourselves out as that market includes the aftermarket, it includes the aftermarket. And as we said before stationary, agricultural, construction, mining, light vehicle will always be the powerhouse. It’s the high volume huge driver of our business. But we’re very product technology focused and very much than it applying those technologies where appropriate to continue to grow the business. And you’ve mentioned something a little about M&A, we done in the past if there is technologies that we believe would enhance that growth that would be synergistic, we’d definitely be taken at look at them and we’ve never taken that off the table, but it’s clearly right the heard of our whole growth strategy is exactly that product technology strategy that we have.

Ryan Brinkman - JPMorgan

Okay, that's super helpful. You mentioned some of the tangential end markets. Is there anything to report during the quarter, any progress or can you just confirm that you've made bookings or in conversations to expand your business on the marine power side or the stationary power side or some of those other exciting areas?

Gregg Sherrill

I don’t know that anything is really at the point of “Booking” if you will. Certainly, we are working with various customers around the world in any of the markets that I just named as a matter of fact.

Ryan Brinkman - JPMorgan

Okay and then just last question, if you have any thoughts on the latest development that you are seeing out of China as regards to stricter commercial vehicle emission control standards or implementation.

Gregg Sherrill

Well, that the more what we’ve been reporting. I mean, we do see them. Certainly, our volumes are up this year on emission control systems into the commercial vehicle market. It’s so slow ramp up, but it’s positive. At least for talking about, we’re shipping product not when we think we might ship product like we did for so years. And right now, there is certainly some emphasis in China on increasing that coverage moving into 2015, so like everything with China we kind of wait and see. Right now it’s on an upward trend and we’re pretty pleased with it.

Operator

(Operator Instructions) The next question is from Brian Sponheimer and please state your company name.

Brian Sponheimer - Gabelli & Company

Hi, Gabelli & Co. Good morning, guys. Just a couple real quick questions. On the ride control side, we are coming off the worst winter that we've had in quite some time. The roads are still a mess; companies like Monro Muffler Brake are reporting good undercar numbers. Any chance that there is potentially some upside you are not -- that is not quite in your numbers yet for the back half just for flow-through in Ride Performance of a winter that is going to keep giving you good results for the next 12 to 18 months?

Gregg Sherrill

Remember we’re talking about worldwide aftermarket sales and certainly what you’re talking about is specific regions within the United States of America and probably Canada, which is good, and they are positive drivers and we’re still seeing that. So you’re definitely on to something there that that particular piece of our business but we’ve tried to incorporate that into our outlook. We still see Europe being pretty weak and South America we believe will continue to be strong like it was in the second quarter maybe not quite as strong but all that kind of factored in.

Brian Sponheimer - Gabelli & Company

Right, of course. And then, Ken, just real quick, what was the motivation for the buyout offer for the retirees now versus say six months ago, six months from now?

Ken Trammell

Certainly we look at a lot of factors clearly number one I think Department of Labor Regulations would require us to be funded more than 90% on the plan and before we get offer a large buyout which is I think this would call buy so certainly they had impacts. And as you know we’ve been working to get the funding levels up at this plan for a number of years. And we also look at discount rates. The discount rates have trended down just a bit this year so it looks like its better timing to do it before the end of the year than to do it sometime next year.

Operator

Thank you. The next question is from Richard Hilgert and please state your company name.

Richard Hilgert - Morningstar

Thanks for taking my questions, guys. On the revenue, value-add was up a little more than the regular revenue was up. The materials that go into the substrate, you've got platinum being a little off year over year, palladium being up significantly in the mid-teens year over year. Does that mean that given the way that your revenue worked out, the material and the substrate that goes through the pass-through is more weighted towards the platinum than it is the palladium?

Gregg Sherrill

Richard not necessarily I couldn’t tell you what the mix of platinum palladium and rhodium is sort of across all of the substrates our customers specify that and that is something that happens sort of between the customer and the tier two coder. So consequently I couldn’t tell you for sure what the mix is. Remember though that when you’re talking about our value add revenue versus our total revenue you’re also factoring in what happens in the Ride Performance side of the business and what happens in the aftermarket side of the business. And in both of those businesses total revenue is value add revenue so obviously there are number of factors that go into that and not just pricing for palladium and platinum.

Richard Hilgert - Morningstar

Okay, very good. In South America, the difference there between what happened in aftermarket and OE, is it really just that the OE market being down like it is driving people to maintain their cars more or was there something else going on there that drove the aftermarket business?

Hari Nair

It was really the downturn in the OE light vehicle production rate in South America particularly obviously with what’s happening right now in Brazil as the economy is fairly weak plus in Brazil and somewhat to a lesser extent Argentina government incentives as it relates to taxes on new car purchases has a big impact. So why we’re seeing as the OE business is down but the aftermarket business has stayed relatively strong so it’s that same counter cyclical impact that we’ve seen that you saw back in 2008-2009 in North America when we’re going through sort of through the financial crisis.

Gregg Sherrill

And that impacts us positively on our Ride Performance business. We actually do not participate in the aftermarket on the Clean Air side of the business in South America.

Richard Hilgert - Morningstar

Okay, right. The slides you had, South America from IHS being down only 11% for the full year that seems to imply somewhat of a comeback in the second half. Is that what you are seeing with your schedules down there and what are your thoughts on what could happen with this economy down there in 2015?

Gregg Sherrill

Again it’s going to be so dependent on what the government does relative to interest rate incentives or tax incentives or whatever it is, they do on such a regular basis down there. We are not really seeing a change, looking six weeks out which is about what we will see in our schedules in the second quarter.

Operator

Thank you. Our final question today is from Ravi Shanker and please state your company name.

Ravi Shanker - Morgan Stanley

Thanks, Morgan Stanley. Good morning, everyone. Just a couple of questions here. You had said that for the third quarter you expected your performance to be in line with the overall industry. Any idea what you expect for the fourth quarter or is it too early to tell?

Gregg Sherrill

We will really give you some better visibility, Ravi, when we have at which will be at the end of the third quarter call. Some of the trends that we have talked about driving the third quarter certainly will continue into the fourth quarter like changeover of some of our larger platforms I think someone mentioned for example before the F1 ‘15 so that will certainly have some impact in the quarter but those are always timing difference.

Ken Trammell

And we will have to see how those ramp ups go because it’s really important for us.

Ravi Shanker - Morgan Stanley

Understood. And just also on the ZF TRW deal, I believe you have a relationship with both those companies, one on the customer side, one of the supplier side. Any take on what that potential combination would mean for you guys, if anything?

Gregg Sherrill

No, we don’t really think it would have that big of an impact on us with relationships that we have.

Operator

Thank you. I am showing no further questions.

Linae Golla

Great and then this concludes our call. An audio replay will be available on our Web site in about an hour. You can also access a recording of this call by telephone. In North America, you may reach the playback at 888-445-8680. For those outside North America, the number is 203-369-3155. This playback information is also found in our press release. Thank you for joining us today.

Operator

Thank you. This concludes today’s conference. Thank you for joining. You may disconnect at this time.

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