Goodyear Tire & Rubber (GT) Richard J. Kramer on Q2 2016 Results - Earnings Call Transcript

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Goodyear Tire & Rubber Co. (NYSE:GT)

Q2 2016 Earnings Call

July 27, 2016 9:00 am ET

Executives

Christina Zamarro - Vice President - Investor Relations

Richard J. Kramer - Chairman, President & Chief Executive Officer

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Analysts

David Tamberrino - Goldman Sachs & Co.

Ryan Brinkman - JPMorgan Securities LLC

Itay Michaeli - Citigroup Global Markets, Inc. (Broker)

Brett D. Hoselton - KeyBanc Capital Markets, Inc.

Patrick Nolan - Deutsche Bank Securities, Inc.

Emmanuel Rosner - CLSA Americas LLC

Operator

Good morning. My name is Tony, and I'll be your conference operator today. At this time, I'd like to welcome everyone to The Goodyear Tire & Rubber Company's Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you.

I would now like to hand the program over to Christina Zamarro, Goodyear's Vice President of Investor Relations.

Christina Zamarro - Vice President - Investor Relations

Thank you, Tony, and thank you everyone for joining us for Goodyear's second quarter 2016 earnings call. Joining me today are Rich Kramer, Chairman and Chief Executive Officer, and Laura Thompson, Executive Vice President and Chief Financial Officer.

Before we get started, there are few items we need to cover. To begin, the supporting slide presentation for today's call can be found on our website at investor.goodyear.com. And a replay of this call will be available later today. Replay instructions were included in our earnings release issued earlier this morning.

If I could now draw your attention to the Safe Harbor statement on slide two. I would like to remind participants on today's call that our presentation includes some forward-looking statements about Goodyear's future performance. Actual results could differ materially from those suggested by our comments today.

The most significant factors that could affect future results are outlined in Goodyear's filings with the SEC and in our earnings release. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Our financial results are presented on a GAAP basis, and in some cases, a non-GAAP basis. The non-GAAP financial measures discussed on our call are reconciled to the U.S. GAAP equivalent as part of the Appendix to the slide presentation.

And, with that, I'll turn the call over to Rich.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Thank you, Christina, and good morning, everyone. This morning, I will review highlights from our second quarter, provide an update on the industry and the key markets in each of our regions, and give my perspective on our business for the remainder of the year. Laura will follow with a financial review of each of our businesses and an update to our outlook before we open the call for your questions.

In the second quarter, we delivered segment operating income of $531 million, reflecting strong performance across the company. That's a second quarter record in our core segment operating income, which I'll remind you, excludes Venezuela from our 2015 base. Our operating performance helped drive a nearly 40% increase in our adjusted EPS of $1.16.

Our second quarter was anchored by a 37% increase in operating income in our EMEA business unit. Our Asia Pacific business also continued its strong performance with a nearly 10% increase in earnings. Combining this quarter with our record first quarter, our segment operating income for the first half of the year was $950 million, the highest first half ever for Goodyear.

In addition, we delivered overall segment operating margin of 13.7% in the second quarter, an increase over last year. The Americas provided more than half of our SOI and its underlying operations continue to remain solid. Furthermore, all three of our global businesses are in segment operating margins of more than 11.5%.

Taken in total, our segment operating performance reflects the unwavering execution of our strategy, which has proved its strength even in volatile market conditions. Our consistent progress has resulted in steady earnings growth and positions us well for that growth to continue. I'd like to spend the next few minutes providing my perspective on each of our SBUs as well as my thoughts on the industry outlook for the remainder of the year.

The Americas, which as a reminder, now includes both our North America and Latin America businesses delivered $291 million of operating income. As expected, its earnings were less than last year because of a few discrete items in the quarter. Laura will provide more detail on those items in her remarks.

Nonetheless, the Americas' underlying business performance remains strong and continues to demonstrate the earnings power of the value proposition in our core business. Demand remain robust for our premium HVA tires and particularly in light truck and SUV. These segments take advantage of our strengths and continue to drive growth in mix in our U.S. business.

We continue to see strong demand for our Wrangler DuraTrac and our Wrangler All-Terrain Adventure products. In addition, our fitments for passenger cars also performed very well in the quarter specifically our Eagle RS-A, the Eagle F1 Asymmetric All-Season and the Assurance ComforTred.

In broader industry terms, the underlying fundamentals in the U.S. such as miles driven, gasoline prices and fuel consumption remain favorable. Americans used an average of almost 9.8 million barrels of gasoline a day in the four weeks ending July 1, the highest level since the Energy Information Administration started collecting weekly consumption data 35 years ago.

Also, while the SAAR is moderated from its peak levels, SUV and light truck vehicle growth has increased 6% over the last 12 months. The OEs depend on the technology and the performance characteristics of Goodyear's high-value-added products for SUV and light truck fitments. And these are the type of platforms we target with our OE strategy; and it's working.

The U.S. replacement industry data on the whole however reflected softer volumes in the second quarter compared to a year ago. As we've outlined on slide six, this decline was primarily as a result of a higher than normal level of imports in the second quarter of last year. You'll recall imports were abnormally low in the first quarter of 2015 following the announcement of the U.S. tariffs on Chinese imports. The situation was exacerbated by a port strike making product flow difficult for many importers.

As a result, the second quarter of 2015 saw about 15 million more imported tires than the first quarter. And separately, we've seen some destocking at the dealer and distributor level for some broader market products this quarter. Our view is that this excess inventory was concentrated towards the lower end of the market in the economy and mid-tier segments.

If we take a step back from the quarter, the year-to-date industry sell-in for consumer replacement is up 1%. What's important to note is that within that growth is an increase in rim sizes of 17-inch or greater of 9%. Since the SAAR recovery began in 2010, we've seen several years of growth in OE with the mix shift to those premium tires. Rim size of 17-inch or greater grew from 49% of the OE market in 2009 to 73% in 2013. We're seeing the benefit of that mix shift in the replacement market as well.

Tire sizes of 17-inch and greater grew 10% and 7% in the first and second quarter respectively. And we're outperforming in this portion of the market. The Goodyear brand nearly doubled the industry in growth in 17-inch and greater rim sizes in the second quarter. This is exactly what our OE strategy was designed to do.

As you know, we've been investing in our U.S. plants to increase our capability to supply more premium HVA tires. Some of that investment has been in CapEx, and some in engineering and shifts in production within our existing footprint. We're continuing to increase our capability to grow in this profitable segment.

Looking ahead, we expect that the overall U.S. industry will remain weak in July as a result of the highest import comparable from all of 2015. In the intermediate to longer term, we continue to feel very confident about the fundamentals in the U.S. and continue to expect strong demand for our HVA products.

Turning now to Brazil, economic conditions there remain challenging during the quarter. Industry shipments and consumer replacement were down about 2% and OE continued its steep decline. Despite the macroeconomic headwinds, Brazil's profit contribution was once again positive in the quarter. We feel very good about our ability to drive growth in mix in HVA segments in Brazil over the long-term, and while the economic recovery isn't around the corner, we believe that we're well-positioned in the marketplace when it does occur. And we do believe that it will occur.

Now, shifting to Europe, our EMEA business unit delivered $148 million in operating income during the second quarter. That's a 37% increase, driven by strong volume in both consumer OE and replacement. Industry sell-in remained healthy during the second quarter, especially in OE, which was driven by higher production levels in Western Europe. New passenger car registration grew for the 34th month in a row in June, posting growth of more than 9% in the first half of the year.

European auto companies' preference for premium, large rim diameter HVA tires, including Goodyear's high performance lines are driving mix up in OE and later on in replacement across the region. And we're delivering award-winning products to meet that demand. We recently launched the new Eagle F1 Asymmetric 3, ultra-high performance tire, an industry-leading product for Europe's growing OE market. The new member of the Eagle family was tested by leading organizations and outperformed other brands in both dry and wet conditions, as well as in durability, leading to demand pull from our premium OE customers across the region.

In EMEA consumer replacement, we saw a strong growth in our SUV and light truck segments as Goodyear-branded summer tires, particularly EfficientGrip SUV tires claimed the top spot in several important magazine tests.

As we look to the second half of the year, we are again taking a measured approach to winter tire sales based on the warmer weather we've seen in the region over the past several years. Although, the winter inventory situation is more balanced heading into the selling season versus last year. Our plan is based on a green winter, and weather aside, our products are positioned to win in the marketplace. The strength of our winter tire portfolio combined with an attractive value proposition for our customers, has us well-positioned to make the most of winter industry demand.

Finally, as you know, we've been focused on our cost initiatives in the EMEA and improvements in this area also contributed to the regions earnings in the quarter. With the economic uncertainties surrounding Brexit and its impact in Europe in the intermediate and longer term, we will remain both agile and diligent on cost actions in this changing market.

In Asia Pacific, we achieved record segment operating income of $92 million with volume growth of 21%. Our unit volumes were up 4% excluding the impact of our newly reacquired Japanese replacement business. As we've seen in prior quarters, volume growth was robust in our China consumer business, but there was further deterioration in Australia due to ongoing challenges in the country.

China had a strong second quarter with Consumer Tire volume growth of 8% and double-digit growth in the SUV and light truck segments. We've had success in both OEM replacement in winning new Chinese OE accounts in a strong execution of sell-through programs building upon our expanding service and retail network there.

Consistent with our strategy, we grew in Asia Pacific with the right mix of products. As an example, Asia Pacific scored product wins with its Sport Maxx high-performance tire which was awarded Best-in-Class in the 2016 MOTOR Magazine Tyre Test. Sport Maxx outperformed its competition in all five of the tested performance attributes beating the competing tires by the biggest margin in eight years.

Designed for a wide range of high-performance vehicles, our innovative products are driving demand in the region. We remain very optimistic about the long-term value proposition of our business in Asia Pacific. Our new product introductions, growing OE relationships and increasing points of distribution give us confidence that we will continue to be successful and grow in this important market.

Looking back at our global businesses in the second quarter, and over the first half, I'm very pleased with our record results which were driven by strong demand in premium HVA products across our regions. The Goodyear brand and our value propositions continues to be a competitive advantage in the marketplace. Goodyear's value proposition has many elements, including a trusted iconic global brand, industry-leading products, diverse distribution channels capable of responding to customer requirements, strong customer relationships, particularly at the OEMs and an unwavering focus on the consumer.

Our teams have made the commitment to winning with consumers and helping our customers build their businesses everyday while taking the long view of creating sustainable value. Our first half results demonstrate that, and we are focused on execution across our markets by pursuing profitable volume and share in segments where the Goodyear brand is a differentiator. We are committed to our target of 10% to 15% annual growth, or $2.1 billion to $2.2 billion of segment operating income in 2016. We look forward to discussing emerging trends in our industry and our strategic plans for the future as part of our Investor Day on September 15.

Now, I'll turn the call over to Laura.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Thank you, Rich, and good morning, everyone. Today, I will cover our second quarter results and provide more detail on key income drivers in the quarter. I'll also provide an update regarding our full year outlook for 2016 before we open the call up for your questions.

Turning to the income statement on slide eight, you will see our results for the second quarter. Consistent with our presentation in April, we have provided call-outs that highlight the effect of deconsolidating Venezuela. Looking at the income statement items as reported for the second quarter, the sales comparison to prior-year was negatively impacted by the deconsolidation of Venezuela, which had $115 million of net sales in the second quarter of 2015. Similarly, other tire related revenues were lower by $86 million, driven by the 2015 sale of the North American motorcycle business.

Additionally, the strengthening of the U.S. dollar against foreign currencies reduced sales by $84 million year-over-year. Our gross margins were stable at 27.5% and segment operating margin increased 50 basis points in the quarter. Excluding the impact of Venezuela, SOI margin increased 1 full point.

Our earnings per share on a diluted basis was $0.75. Our results were influenced by certain significant items. Adjusting for these items, our earnings per share with $1.16. I'll note that our segment operating income in the quarter was impacted by a $24 million unfavorable out-of-period adjustment related to the elimination of intercompany profit in the Americas region. The correction is related primarily to 2012 to 2015 prior period financials with the majority attributable to 2012. This amount is included as a significant item in the adjusted net income.

Turning to the step chart on slide nine, which walks second quarter 2015 segment operating income to second quarter 2016. After adjusting for the $36 million impact of Venezuela, our 2015 core SOI was $514 million. The benefit of higher volume in the second quarter and higher production levels in the first quarter drove an overall improvement of $21 million. Lower raw material cost of $49 million more than offset reduced price mix of $44 million for a net benefit of $5 million during the quarter.

Cost savings actions of $66 million driven by our operational excellence initiatives more than offset the negative impact of inflation, delivering a net benefit of $33 million. Foreign currency exchange was a headwind of $10 million reflecting the continued strengthening of the U.S. dollar, particularly against the Argentine peso, the Canadian dollar and the Brazilian real.

Other was lower by $8 million and includes a $14-million impact of the divestiture of our North American motorcycle business which was partially offset by lower incentive compensation of $10 million. In summary, we achieved another record quarter with growth in core SOI of 3%. Excluding the impact of the out-of-period adjustment, our core SOI was $555 million and growth was 8%.

Turning to the balance sheet on slide 10. Cash and cash equivalents at the end of the quarter were $1.1 billion. Net debt is up versus year-end which reflects the normal working capital seasonality in our business. Versus the prior-year period, the increase includes the impact of Venezuela's deconsolidation.

Free cash flow from operations is shown on slide 11. For the quarter, we generated $99 million of cash. Working capital was a use of $75 million of cash and in line with the typical seasonality of our business. Additionally, cash flow from operating activities was $261 million for the three months ended June 30.

Now, let's move to the business units on slide 12. The Americas generated segment operating income of $291 million in the second quarter, or 13.9% of sales. The year-over-year decline in SOI is more than explained by several noteworthy items that totaled $79 million: First, the $36 million impact of the deconsolidation of Venezuela. Second, the $24 million out-of-period adjustment, primarily related to 2012. And third, a $19 million impact from the sale of GDTNA business last year.

The Americas also saw higher conversion costs in the quarter, due to additional engineering activities and a shift in production to increase our supply of HVA tires. Despite these headwinds, our core business in the Americas continues to be strong. The execution of our strategy enables us to continue to realize positive price mix performance. Customers are demanding more of our HVA tires, particularly premium, SUV and light truck tires.

Unit sales in the second quarter were 18.8 million, or down 6% versus 2015. In OE, our unit volume decreased by 900,000 units. The sale of GDTNA, which included sales of Dunlop-branded tires to Japanese OEMs in the U.S. explains almost half of the decline. And we also saw OE declines in both Brazil and in the U.S. Excluding the impact of Venezuela, our replacement volume was flat.

In summary, and despite several notable headwinds within the Americas region, the underlying performance is solid. The quarter also offers proof of our margin sustainability. Excluding the out-of-period adjustment, the Americas achieved SOI margins that was higher than last year. We accomplished this margin improvement in markets that were softer and with significantly lower raw material tailwinds. This performance is validation of the strength of our strategy, product and the Goodyear brand in the marketplace.

Turning to slide 13, Europe, Middle East and Africa continued to deliver positive results with segment operating income of $148 million in the quarter, up 37% compared to prior year. This was the third consecutive quarter of year-over-year earnings growth driven by higher production and sales volumes throughout the region, as well as our continued focus on cost savings initiatives.

Volume was up more than 4% compared to last year, and was driven by growth in both consumer OE and replacement channels. Strong demand for Goodyear products resulted in an 8% increase in consumer OE units, and consumer replacement volumes were up almost 3% in the quarter. Winter industry demand also increased more than 10% year-on-year in the quarter, evidence of channel inventories being more normalized this year.

Our commercial truck business also continues to deliver consistent results with volumes up almost 4% in the quarter. Our EMEA business delivered very strong performance in the second quarter of 2016. We remain confident in our team, our product portfolio, and in our ability to deliver sustainable revenue and profit growth.

Turning to slide 14, Asia Pacific delivered record second quarter segment operating income of $92 million, an $8 million improvement versus last year. The main drivers continued to be strong volume growth and the benefit of lower raw material costs which were partially offset by lower price mix and increased SAG expenses related to our recently acquired replacement business in Japan. Our segment operating margin in the region increased to 17.4% up from 17.1% a year ago.

Asia Pacific's volume was 7.3 million tire units representing a 21% growth versus last year. Excluding the impact of our acquisition of the Japanese replacement tire business, the remaining volume growth is primarily attributable to our 8% consumer tire growth in China, one of our largest and fastest growing markets in the region. Additionally, the ASEAN countries saw 6.5% growth across our business, which was partially offset by lower volume in Australia. We are well-positioned in Asia Pacific and continue to be excited about the long-term growth and opportunities there.

Turning now to slide 15, I'll cover our full year modeling assumptions for 2016. In summary, our full year outlook and SOI income drivers remain unchanged from our April call. We continue to target $2.1 billion to $2.2 billion in SOI in 2016. With moderating raw material costs since April, we now expect raw material cost to be about 4% lower than last year before cost savings action.

We continue to see our full year price mix versus raw material benefit at around $75 million, unchanged from our earlier outlook. We expect third quarter raw materials to be down about 4% based on current spot rates. The remaining price mix, net of raw materials benefit, should flow evenly across the back half of the year.

In cost savings versus inflation, we continue to expect a benefit of $135 million for the full year. The remaining net cost savings are expected to be more heavily weighted to the fourth quarter. Regarding foreign currency translation, we continue to expect a headwind of approximately $45 million. While current spot rates would imply a slightly more favorable outcome, currencies remain volatile. The divested North American motorcycle business will have a negative $10-million impact year-over-year for the third quarter.

Additional financial assumptions for 2016 are listed on slide 16. Our income tax rate has been lowered to about 28% of global pre-tax operating profit following our experience to date. Cash taxes remain at 10% to 15% of global pre-tax operating profit.

And finally, we repurchased $100 million of shares during the second quarter. We've repurchased $563 million so far under our existing $1.1 billion share repurchase authorization, and we remain committed to repurchasing additional shares through 2016 and early 2017.

Now, we'll open the line up for your questions.

Question-and-Answer Session

Operator

Thank you. We'll take our first question from David Tamberrino from Goldman Sachs. Please go ahead. Your line is open.

David Tamberrino - Goldman Sachs & Co.

Hi, folks.

Richard J. Kramer - Chairman, President & Chief Executive Officer

How are you, David?

David Tamberrino - Goldman Sachs & Co.

Good morning, Rich, Laura, Christina. Thanks for taking our questions here. Just a couple for us. I think the first one would be, in Europe, the strength and sustainability of the margin improvement that you're seeing within the region, a little bit surprising to us. I think it was about a 300-basis point increase in SOI margin year-over-year. As we progress through the remainder of 2016, are you expecting to continue those operational efficiencies to continue and really see double-digit margins in both the third quarter and the fourth quarter?

Richard J. Kramer - Chairman, President & Chief Executive Officer

So, David, good question, I'm glad you focused on it, because we were pretty pleased with the way Europe delivered in the quarter. And I might take just two seconds to give you a view on how we think about Europe overall. We still view it as really a fantastic market despite some of the ongoing, let's say, unsolved economic issues that still linger over there. Remember, the market is growing there, particularly in 17-inch and above, particularly that when you compare it to 16-inch and below, where you're not seeing nearly as much growth, and sometimes it can even be viewed as flat depending on the market. We see the market as still demanding excellent technology driven by the OEMs. We really love the car park that still sits in Europe there. So, we look at it as a great market and add to it then the seasonal market as you bring in winter tires, and the winter tire, the winter-summer switch, really a robust market for us.

The biggest headwind we still see there as we've talked about in the past is the ongoing sort of movement of low-end Asian tires particularly in through Eastern Europe that is has and probably will continue to cause a headwind. And again, it's an example of when tariffs go up in one region, those tires typically move to somewhere else. You may remember in the past, they went down to South America, as those economies slowed and currencies depreciated, tariffs are back in the U.S., now they are in Eastern Europe. So, that's a continued headwind for us over there.

But our goal is to continue to drive mix, continue to align our distribution consistent with our strategy over there. Our focus will be on new products, and leveraging our brands, and to the point you made continuing to focus on our cost actions over there. So, I would say that we've made an improvement in Europe. We would expect those cost improvements to stick with us. I would say we're only on the front-end of fixing our European business over the long-term. Our goal is to do some of the same things we've done in North America and Europe as well, and we feel very good about that. But that's probably not a direct straight line either.

So, as we fight off the low cost tires coming into the East that actually has a negative impact on our mix in Europe, that hide some of the positive impacts we're getting on the 17-inch and above. So, I guess, overall, I would say, we would expect strong results in Europe as we look to 2016 and out into 2017. I would expect that you'll still see some significant cost actions there as we move ahead, as we look at our production over there, and Jean-Claude Kihn and the team over there are very focused on cost, day-to-day cost, as well as structural cost to reduce the fixed cost to that business going forward. So, I feel good. And I would say we're on the front-end of what we expect.

David Tamberrino - Goldman Sachs & Co.

Okay. That's very helpful. Maybe just to follow-up from there, I mean, post the British referendum, have you seen any changes in demand patterns by your dealers and distribution points within the UK, or is it still too early to call?

Richard J. Kramer - Chairman, President & Chief Executive Officer

I would say it's too early. I would also say that before we went to the Euro, a number of years back now, obviously, the European market had a very sophisticated way, or not sophisticated as you might say, but they were very adept at dealing with a currency arbitrage on tires. We would expect to see a little of that as this sort of seeds in, but given that production in UK has been diminished greatly from the period that I am talking about, I don't think we see any significant disruption coming there. We like our business in the UK, and we certainly think we can manage through this.

David Tamberrino - Goldman Sachs & Co.

Okay. That's very helpful. And then, just a last one from me and I'll pass it over. On the cadence for price mix less raw materials, obviously, we've seen oil somewhat creep up sequentially, but still be down year-over-year.

As we think about the go forward, if raw materials do continue to hold the levels where they are and end up increasing year-over-year, how do you expect the P&L to flow for price mix less raws as raw materials increase and then possible prices are passed on to consumers, because the reason I ask is, one of the larger questions or push back that I'll get from investors is really just on the industry being able to be price disciplined. And if there's going to be a quarter or two quarters or after a year or two quarters or three quarters of a year where the tire manufacturers are essentially caught with increasing raw material cost without adding in or passing on those price increases?

And as you look at 2Q results with only a price mix less raw materials of positive $5 million versus first quarter of about $38 million, and you start to question, what's going to change in the back half of the year that's going to maintain net positive price mix over raw materials if in the event that we had the second quarter really being eaten away in a favorable raw material environment?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Okay. So, hey David, maybe I'll walk you through a couple of things to answer your question. So, first of all, the one short answer is price mix versus raws, obviously a big piece of that is mix. And there are some things we're doing in the business that result in a much stronger mix as we get into the second half of the year. So, that's one piece of it.

Now, similar to my opening remarks, as we look at the remaining price mix net of raws benefit, we do see it slowing evenly across the back half of the year. So, when you look at the third quarter and the fourth quarter, to get to our full year guide of the $75 million year-over-year. We see about a 4% decrease in raws in the third quarter, getting to more like down 1% or 2% in the fourth quarter. So, about 4% in the third quarter, maybe down 1% or so in the fourth quarter.

Richard J. Kramer - Chairman, President & Chief Executive Officer

And I might just add to Laura's comments, I think in terms of the markets out there, as we look at high end – the value we're getting in the market for high end tires versus the value that the market is putting out for low-end tires is certainly based on the supply-demand equation as well. So, we feel pretty good about that environment. The demand for those tires is really good.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Very strong.

Richard J. Kramer - Chairman, President & Chief Executive Officer

And that gives us confidence as we look to the back half of the year heading out into 2017. David, the other thing I would just add more is sort of a historical macro comment. We have weathered both significant price increase, raw material increases, and certainly, giving those raw material price increases back, or having those raw material prices increases decrease. And I think our track record is very good at managing both the pluses and the minuses, the increases and the decreases as we manage our business. And as we said, you can have timing differences to catch-up, if you have significant movements in raw materials. But I think our track record speaks for itself, and certainly, we would plan to execute consistent with that track record.

David Tamberrino - Goldman Sachs & Co.

Appreciate the thorough response. Again, very helpful and congrats on the quarter.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Thank you.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Thanks.

Operator

Thank you. Next, we'll move to Ryan Brinkman with JPMorgan. Please go ahead. Your line is open.

Ryan Brinkman - JPMorgan Securities LLC

Great. Thanks for taking my question. Have you learned anything more since the last call about the prospect of U.S. tariffs on Chinese commercial truck tires? I think the proposed countervailing duties are running about 20% on average, and then there is the potential for maybe anti-dumping duties on top of that. So, when are you expecting more clarity on this? Have you run any scenarios yourselves? And I do think it has the potential to have a material impact to 2017 profits?

Richard J. Kramer - Chairman, President & Chief Executive Officer

Ryan, I mean, we sort of follow the same things that are out there in the public domain. And I think that's about what we would just repeat to you in terms of where the processes are. There's certain dates that the government has given on the various steps that they are going to go through. We've dealt with tariffs before on consumer tires. We saw some of the impacts of those. I mentioned that a bit earlier in terms of how products flow and the like, but our view has always been were for free and fair trade as we import and we export around the world. So, we will watch this and we will manage our business accordingly. We did that last time, and we would expect to do the same thing with our truck tires here. And as Laura went through our projections, I think we'll stick with those and you don't see it highlighting anything related to that.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Exactly. I think in what we can be assured of is if this goes into place as it appears it might, we'll have a lot of distortion in the industry numbers, right, ahead of that as it goes pre-buys and all that, that we'll have to work through that we kind of know for sure.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Yeah, no, that's a great point, Laura. Yeah.

Ryan Brinkman - JPMorgan Securities LLC

Okay. Thanks. Very helpful. Then just last question. It's another one on Brexit. Obviously, a lot of uncertainty. I think we got a good grasp on currency translation. So, anything special to think about relative to currency transaction. I mean, I was just looking on your website, it looks like you have one out of 20 plants in the EMEA region, maybe is in the UK. But I don't know about the relative sizes of these plants. Is it fair to say you're a net importer of tires into the UK? Are you able to somehow – do you think it's not going to have a material impact because you can offset this what, because of how you're moving tires around, or because of price increases, or does this have the potential to be material? I think you were saying earlier, maybe no?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Yeah, you're exactly right. The short answer is, we do see it as immaterial. So, we do not manufacture any tires in the UK any longer. In fact, we did some small amount of mixing, maybe a year or so ago, that we announced that we're shutting down. So, we do not manufacture any there. Roughly for us, the UK is maybe about 2.5% of our sales. It's primarily consumer tires, and directly, we import all of the tires into that region. So again, not within – within the UK, not a tremendous exposure certainly like everybody, the larger question is still the whole impact on the Eurozone and growth there over time kind of yet to be determined.

Ryan Brinkman - JPMorgan Securities LLC

Okay. I appreciate it. Thanks.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Thanks, Ryan.

Operator

Great. Thank you. And next we'll move to Itay Michaeli with Citi. Please go ahead. Your line is open.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Good morning, Itay.

Itay Michaeli - Citigroup Global Markets, Inc. (Broker)

Good morning. Good morning, everyone. Maybe just starting off with cash flow, balance sheet. Laura, maybe you could just kind of just bridge us on how to think about the free cash flow second half of the year. And particularly, perhaps the bridge to get to the (40:05) 2.1 times gross leverage target you set out before the end of the year?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Well, sure. So, as we look at the balance sheet, right, and our capital allocation plan, we still have – let me, just kind of the numbers here in front of me, we still have based on achieving our targets this year, some debt repayment to come into play, potentially about $450 million, as we end the year and early next year, so we'll continue on that path, part of the capital allocation plan. You saw us make a debt payment last year. And again, as achieve our target, that's really the biggest movement I think on the balance sheet for the rest of the year.

Itay Michaeli - Citigroup Global Markets, Inc. (Broker)

Okay. That's helpful. And maybe shifting back to mix, you talked about the strength in light truck segments and SUV. I think you've previously disclosed that your Goodyear products are represented on about 75% of the top 15 SUVs and light trucks in the U.S. So, how do we think about kind of the replacement opportunity in these segments in terms of your market share and in terms of the potential incremental mix opportunities in the replacement market in the next two years given the shift that we've seen in the OE market towards these light trucks?

Richard J. Kramer - Chairman, President & Chief Executive Officer

Itay, I think I would say in brief we feel really good about it. And I would say what we're seeing today is the benefit of the team that now Americas had Steve McClellan and his team put together a number of years ago were looking at what was coming in the market, having what we called our OE selectivity strategy which is really about being targeted and saying what are the fitments that we see coming out there, how do we bring our innovation and technology to those fitments working with the OEMs. And then looking at what the replacement cycle is with the target as you know on the early replacements.

As we look at, I think it was slide six in our deck, you can see that the mix is moving up 17-inch above from 49% up to 73% in total. And what it says is, most of those, maybe I shouldn't say most, that's maybe too specific, I don't have the number here. But those tires – those vehicles, I should say out there with a high SAAR that we see still haven't come to first replacement yet. So, we feel really good about those vehicles, those light trucks and SUVs which, as you know, are the top-selling vehicles in the U.S. are going to be coming in for replacements as we look to the future.

So not only do we feel good today and in the past relative to these, we feel pretty good about where that market is going to be in the future. So, that's a gift that's going to keep moving for us as we move ahead. And I would say very intentionally, our goal, as you also know is that we got to keep making those tires.

Itay Michaeli - Citigroup Global Markets, Inc. (Broker)

Great. That's very helpful, Rich. Thanks so much.

Operator

Great. And thank you. Next, we'll move to Brett Hoselton with KeyBanc. Please go ahead. Your line is open.

Brett D. Hoselton - KeyBanc Capital Markets, Inc.

Good morning.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Good morning, Brett.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Good morning.

Brett D. Hoselton - KeyBanc Capital Markets, Inc.

So, first kind of a follow on from a capital allocation standpoint. What are you going to do with the cash after you get our debt down to the level that you'd like to achieve? In other words, I don't see you as a company that's going to go on and do a lot of M&A, you're kind of doing more divestitures and acquisitions at this point in time, and it seems as though the reallocation towards share repurchase may be in order here?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

So you know, Brett, it's good. And this is a lot about what we're going to talk about at our Investor Day, okay? But there is no doubt, right, that just as I walked through on the debt repayment and certainly the pension actions, as we look forward, we do expect the cash requirements for deleveraging to go down, to diminish certainly, okay, as we get to that leverage target. We've taken the pension actions and the debt repayment actions then, so we would have more cash available for other purposes. And that's really where we're going to lay all that out for you on September 15, as part of our Investor Day.

Brett D. Hoselton - KeyBanc Capital Markets, Inc.

And along those lines, another three-year plan is in order?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Well, we're working through that. You know what I mean, it's not for sure that it's three years. We've certainly have a view three, a view five, all that. That's what we're working through at this point, Brett, but it will be a long-term view.

Brett D. Hoselton - KeyBanc Capital Markets, Inc.

Very good. And then, switching gears here. As far as Europe is concern, as I kind of look at European sales, there right now, we've kind of got it running around 60 million units, but back in the good old days, before global warming, we used to do 70 million to 80 million tires. My question is, if we had a white winter, is there any reason why you can't get back to that 70 million to 80 million tire range that you used to be at, let's say, three years or four years ago?

Richard J. Kramer - Chairman, President & Chief Executive Officer

Brett, I think, you have a couple of things going on there. One, I mean, you are correct with a white winter, we, as well as the industry would no doubt sell more tires. I think from a high, we're down, I think, well over 20% from where a white winter would have industry volume. So, definitely, that would be an increase to our volume. And our share in there, our tires, our products in there performed very well. So, that certainly would help us in a significant way.

I'll also remind you, because we haven't had one of these in a while, there is a sell-in season that's going on now for winter tires. And we feel again pretty good about that because the channels are not as full as they've been in the past. But you'll also have a situation where you're making those tires early. So, as we said, we're planning for a green winter. We're not planning for a white winter. That's for inventory and cost purposes. But we are keeping the ability and the flexibility to try to make more of those tires should we get into a white winter and be able to catch-up those. So, that's part of our strategy.

I would say the second thing, just in general, on EMEA volumes, what you're also seeing there is sort of an intentional mix shift towards us not just going volume for volume, but looking at how we concentrate on HVA tires in both the OE and the replacement markets as well as in certain geographic markets. And by also doing that and making investments to do that, we are also then not pursuing aggressively, not volume for volume sake, some low-end tires that are just not a place where the Goodyear-Dunlop brands can add value and where our value proposition doesn't play well.

We see in Europe just like we used to see in the U.S. and still do in some cases sort of a four tires for $99. You see those same type of offerings in certain parts of Europe. That's not where we're going to play. It's not where we can deliver the value that our investors would expect from us. So, that's playing into it as well.

Brett D. Hoselton - KeyBanc Capital Markets, Inc.

Thank you, Rich. Thank you, Laura.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Okay. You're welcome.

Operator

Great. And next we'll move to Rod Lache with Deutsche Bank. Please go ahead. Your line is open.

Patrick Nolan - Deutsche Bank Securities, Inc.

Good morning, everyone. It's actually Pat Nolan for Rod.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Hi, Pat.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Good morning, Pat.

Patrick Nolan - Deutsche Bank Securities, Inc.

Two questions. First, just a follow-up on the price mix versus raws. So, it looks like you're getting a little bit bigger benefit from raws than you were previously expecting. It still sounds like you're going to get positive price mix. I think, if I'm correct, I think the previous plan assumed that you needed to get some price towards the back end of this year. Is that no longer the case that you need to put through price to achieve the goal for the year?

Richard J. Kramer - Chairman, President & Chief Executive Officer

Well, Pat, I think as we look around the world, the answer to that question is obviously a complicated one, because markets are different. I would say, as we look to some markets like Brazil or Latin America, where we have significant currency devaluations and we've seen raw materials, not just natural rubber, dollar-based raw materials go up, we are continuing to manage as you'd expect. We've announced price increases in Brazil, for example, from Q3 2015 all through to Q1 2016, because of the devaluation that we've seen in the currency there. So, there is a market we will continue to be very active trying to get the value for our products in the marketplace.

Other markets obviously have different stories. I won't go through everywhere like that. But I would say that the world around excess capacity, again, I'll use Brazil as an example, where the OE business was down again about 20% in the quarter, we've got to be very vigilant in managing price mix versus raw materials. So, it's very hard to answer that question in one way, I would say definitely, we are going to continue down the path to do that.

Patrick Nolan - Deutsche Bank Securities, Inc.

Maybe just to drill down on that. So, it sounds like the inventory issues seem to be more concentrated in the low end, particularly in North America. Do you think – can the industry put through some upward movement in price based on what we've seen raws do over the past year?

Richard J. Kramer - Chairman, President & Chief Executive Officer

Yeah, we can't comment on what the industry can do Pat, that's a tough one for us.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Yes.

Richard J. Kramer - Chairman, President & Chief Executive Officer

I can tell you our view is, we have a value proposition out there around products, around innovation, around brand, around promotion, around advertising, around bringing solutions to customers in both consumer and commercial, and that value proposition is what we try to win in the marketplace with.

Patrick Nolan - Deutsche Bank Securities, Inc.

And Rich, I was curious if you give us your perspective on the North American volumes. I mean, if you look at the RMA member volumes based on your slide, down slightly year-to-date. But all the trends as you guys have highlighted, whether it's miles driven, gasoline usage, all these trends point to what should be an improving demand dynamic. What do you think is restraining that volume growth for the industry?

Richard J. Kramer - Chairman, President & Chief Executive Officer

No. I'd tell you, it's a very good question as we think through this, Pat. I think there's a couple of things that are happening as we sort of dissect this. And if we think about it, what we're still seeing, and what we have seen for a while is sort of that consistent sell-out. Remember sell-out tends to follow GDP over time. There can be dislocations, but sell-out and GDP tend to be a pretty correlative thing over a period of time.

What we're seeing right now, again, as Laura alluded to it is, really how tariffs have disrupted some of the RMA figures that are out there. So, if I could walk you through a couple of things very quickly, and you can I think refer back to slide five, it is in our deck. But remember, in the second half of 2014, you had a really big pre-buy ahead of the tariffs coming into the market. What that did was in Q1 2015, you remember we said this last quarter, we had a pretty easy comp, because if you think about just behaviorally, the channel stopped buying as they bought a lot of in the second half of 2014. What they did in the second quarter of 2015, was start to restock again. And as they did that, our Q2 2015 to Q2 2016 comp became tougher.

So, you see on a gross basis, a little growth happening, but it's really, again, all because of imports coming in and the volumes at the low end of the market. And I think, Laura also made the comment, or I made the comment that, you're going to see that continue in the month of July, because it's actually highest comp in the year where you saw a lot of restocking going on in the channel.

So, I have you think about, if I could maybe put that part a little more succinctly, tariffs really do distort the industry as we go. Those tariffs really impact the low end of the market, which is not where we play, it's not where we focus, we're focusing on that 17-inch and above. And 17-inch and above, as we showed you, we saw in Q1 and Q2, that market grew 10% and 7% using the USA numbers of the industry. So, I think, you are actually seeing good growth in that part of the market where you don't see it distorted by the tariffs. So that's one element of it.

The second element of it, I would say, we look at it vehicle miles traveled, gasoline usage to SAAR, everything is pretty good. But you have to remember we kind of say all vehicle miles traveled aren't created equal. So, you have a lot of new cars on the road. I think I mentioned this earlier, that really haven't come in for that first replacement yet. So, you got a lot of new cars that are continuing to drive those vehicle miles traveled.

And you also have to remember, RMA numbers are based on sell-in not sell-out where vehicle miles traveled would be rubber burning on the road which would be more akin to a sell-out number, not a sell-in number. So, when you have all those distortions happening with the channel on sell-in because of tariffs, you see this sort of at the moment dislocation between sell-in and sell-out, or said another way that the RMA is reporting of what's actually happening out in the marketplace.

So, we would think those two things are going to come together as we get some consistency in terms of comps over time. And we'd say, we're really very pleased at what's happening because the market of 17-inch and above, or HVA, we use that 17-inch and above to sort of highlight this in the slide, the HVA markets are really moving in a very positive way. And as I said earlier, that's something we feel really good about, particularly as we look out to the future, because those haven't hit the replacement market yet. Our issue is, we just got to keep making more of those tires. So, long story, but hopefully that helps.

Patrick Nolan - Deutsche Bank Securities, Inc.

No, it's helpful color. I'll get back in the queue. Thank you very much.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Thank you.

Operator

Thank you. Next, we'll move to Emmanuel Rosner with CLSA. Please go ahead. Your line is open.

Emmanuel Rosner - CLSA Americas LLC

Hi. Good morning, everybody.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Good morning, Emmanuel.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Good morning, Emmanuel.

Emmanuel Rosner - CLSA Americas LLC

So, first just quick housekeeping questions on your adjusted income statement. There seem to be a $20 million other income in the quarter. And I was curious if you just know off hand what this relates to and sort of what kind of run rate we should be expecting for that?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

So, in the quarter, right, we had about $20 million in that other income and expense line. It includes $44 million of redemption premium related to those $900 million of senior notes that we did, I believe, in June. It's offset slightly by that $4 million recovery of the asbestos past costs that we had in the quarter as well. And then the $10 million in kind of our change in assumptions related to the insurance recoveries for asbestos. So, all of that kind of built in to that Q2 of about $20 million. Now, both the $44 million and the $4 million on asbestos for the recovery of past costs have been adjusted out of the net income in our presentation of the adjusted net income.

Emmanuel Rosner - CLSA Americas LLC

Right. So, the adjusted $20 million income excluding all these sort of like unusual, is that something that's – I mean this other income adjusted, is that something that's sustainable?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

I think you have – like I said, the unusual ones are the $44 million and the $4 million.

Emmanuel Rosner - CLSA Americas LLC

Yes.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

So, I think, as you think about other income going forward, normalize it for that.

Emmanuel Rosner - CLSA Americas LLC

Yes. Okay. Understood. And I guess sort of, looking sort of at your global SOI growth in the quarter on a organic basis sort of trying to exclude Venezuela for example. It seems like it was about up 8% year-over-year, so a little bit of maybe a deceleration versus Q1. How do you think about that sort of like going forward in the context of your full year guidance of still 10% and 15%? And in particular, what sort of factors would enable you to reach sort of the higher end of the guidance?

Richard J. Kramer - Chairman, President & Chief Executive Officer

So, Emmanuel; as we said, we're sticking to our guidance and we feel good about that. But I can tell you that the one thing about the tire industry is it doesn't move in a straight line. So, while we feel good about where we're going for the year, we had some – as I think Laura mentioned, some incremental cost headwind coming in particularly in the Americas in the second quarter. That's reflected in the numbers.

Hey, look, those things can happen as we move ahead. We got to manage through those, that's what we're hired to do here, and we feel confident about doing that. I don't think the 8% in the second quarter – 8% adjusted as you just said would give us any different view, nor would I suggest to give you any different view about how we feel. That said, the markets are – this is a tough economy, Latin America still hasn't recovered. That's tough now, upside later. So, we're working hard every day to deliver these numbers.

Emmanuel Rosner - CLSA Americas LLC

And can you sort of just go back over these cost headwinds; I mean, I'm not talking about the sort of like unusuals, but sort of like, on a clean underlying basis, ex-items, what sort of like extra spendings sort of happening in the Americas currently?

Laura K. Thompson - Chief Financial Officer & Executive Vice President

Yeah. So, I think, all the details would be in the 10-Q as we go, but as I walked it through in my script, so certainly, you go through taking Venezuela of $36 million out of the prior year, right? We had the divestiture in North America, the motorcycle business, GDTNA, that's about $19 million out of the second quarter of last year.

And then again, as we talked about and guided to frankly for the second quarter, we did have in the Americas a cost headwind of just about $30 million. And we called that out so, you could model for that for the second quarter. But going forward, all the cost is just built into the guidance, right? The cost savings versus inflation, okay? So, that's kind of when you look at the second quarter, that's really the extra that hit in the second quarter, and it isn't there for the full year on our 10% to 15%, or $2.1 billion to $2.2 billion.

Now, the $29 million, as we said back in the first quarter, is really some extra labor, it's engineering expense, it's really everything we've done to shift more and more to those more complex HVA tires, and that does add costs. But, the margin with that the benefit from that more than offsets it.

Emmanuel Rosner - CLSA Americas LLC

Great. Thank you very much.

Laura K. Thompson - Chief Financial Officer & Executive Vice President

You're welcome.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Thanks, Emmanuel.

Operator

Thank you. And that is our final question. We appreciate your participation. You may disconnect anytime. And please have a great day.

Richard J. Kramer - Chairman, President & Chief Executive Officer

Thank you.

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