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Navistar International (NYSE:NAV)

Q1 2012 Earnings Call

March 08, 2012 9:00 am ET

Executives

Heather Kos - Vice President of Investor Relations

Daniel C. Ustian - Chairman, Chief Executive Officer, President, Member of Executive Council, Chairman of Executive Committee, Chairman of International Truck & Engine Corporation, Chief Executive Officer of International Truck & Engine Corporation and President of International Truck & Engine Corporation

Andrew J. Cederoth - Chief Financial Officer and Executive Vice President

Jack J. Allen - Former President of the Engine Group of International

Archie Massicotte - President

Eric Tech - Director and President of Engine Group - Navistar

Analysts

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Jerry Revich - Goldman Sachs Group Inc., Research Division

Ann P. Duignan - JP Morgan Chase & Co, Research Division

J. B. Groh - D.A. Davidson & Co., Research Division

Patrick Nolan - Deutsche Bank AG, Research Division

Timothy J. Denoyer - Wolfe Trahan & Co.

Vlad Bystricky - Barclays Capital, Research Division

Seth Weber - RBC Capital Markets, LLC, Research Division

Robert Wertheimer - Vertical Research Partners Inc.

Operator

Good morning, everyone, and welcome to the Navistar International Corporation First Quarter Earnings Release. Today's conference is being recorded. For opening remarks and introductions, I would like to turn the program over to Vice President of Investor Relations, Heather Kos. Ms. Kos, please go ahead.

Heather Kos

Good morning. Before we begin, I'd like to cover a few items. A copy of this morning's press release and the presentation slides that we will be using today have been posted on our Investor Relations website for your reference. The financial results presented here are on a GAAP basis and, in some cases, on a non-GAAP basis. The non-GAAP financial measures discussed in the call are reconciled to the U.S. GAAP equivalent as part of the appendix in the slide deck.

Finally, today's presentation includes some forward-looking statements about our expectations for future performance. Actual results could differ materially from those suggested by our comments made here. For additional information concerning factors that could cause actual results to differ materially from those projected in today's presentation, please refer to our most recent reports on Form 10-K and 10-Q and our other SEC filings. We would also refer you to the forward-looking statements and other cautionary note disclaimers presented in today's material for more information on the subject.

And now, I'll turn it over to Dan Ustian.

Daniel C. Ustian

A.J., why don't you start us out with the agenda and talk through the first quarter results, please?

Andrew J. Cederoth

Good morning. As you can tell today, we're taking a different approach to the call. Given the significance of the results, we're going to get right into the major pieces of the income walk. I'll walk you through the quarter and then turn it over to Dan to outline for you our plan to bounce back from this quarter and deliver full year earnings in a range that gets us close to $5 per share. Then I'll come back and update our cash position and discuss more about our focus on margin expansion. Included in the appendix are all the normal slides that we traditionally use so that you can reference those at your convenience. So let's get started.

On Page 5, summarized here are the results of the quarter. In total, the loss was $2.08 per share. We've separated these into 2 columns because as you can tell, the impact of the warranty charge can overwhelm the results. Carving out the warranty and despite several operational issues that we discussed last month, segment profit was positive, offset by higher health care costs, resulting in a loss of $1.02 per share.

As I said, the impact of the warranty charge was significant. We did record an adjustment to our accrual for engine warranty of $112 million, of which this is separated into 2 significant buckets. This is broken out for you on Page 6. It's important to remember that the accrual is an estimate of future payment. It's noncash and management actions can positively influence this accrual in the future.

So what many of you may be asking is, how did we end up with such a large adjustment? As you may know, warranty reserves are intended to be estimates. We test these estimates at the end of each quarter for any material movement. We track the actual spending and compare this against projected spending to determine the adequacy of the reserve. The projected spending is based on frequency of repairs and cost per repair. What happened in Q1 isn't so much driven by the absolute increase in spending, but rather the deviation from the estimate. It's also important to note that these estimates are built around historical data, not anticipated future data.

So let me give you an example, particularly as it relates to the 2010 engines. As we have refined the calibration of these engines and improved their performance, this has resulted in an unusually high frequency of repair on a couple of significant components. While our analysis supports that this is a spike and that this will correct itself in the future, the trend cannot be ignored. Thus, we have to acknowledge the higher frequency of repairs in our accrual. It's important to note that these calibrations have stabilized and we expect the frequency of repair to normalize over time. Thus, we believe there's an opportunity for some of this accrual to be reduced as we move forward. Also, we've taken action to reduce our cost for repair and implemented field actions that we believe will reduce future spending as well, but we cannot recognize these opportunities until such time as the data supports the change.

Beyond warranty, the first quarter contained several other events that contributed to the loss. These are summarized on Page 7. We discussed health care at Analyst Day, but the impact to the quarter was $49 million, and for the year this is close to $200 million, which is approximately $90 million more than 2011. We discussed our strategy around reopening the Indianapolis foundry. This has allowed us to alleviate some capacity constraints around castings and to lower our costs. With that, we explained we would have some start-up costs in Q1.

Additionally, MWM in Brazil experienced some production interruptions associated with weather issues in Asia. These issues disrupted the flow of components to a major customer, which ultimately impacted the flow of engines to the same customer. Coupled, these issues within engine had a $20-million impact but we expect to overcome these for the full year.

We've already discussed that 2012 will be a year of lower military revenue, but equally impactful is the reduction of tactical wheeled vehicles within that revenue mix. We like what we have with our military business, because this is a business that even in down years is capable of generating 10% margin.

Going back to Analyst Day, we talked about the start-up status of our businesses in India and Brazil. These both had an impact in the quarter but we expect that each business will improve as the year progresses. We did have a minor issue around engine supply for our global products. Recall, we purchased these engines but we believe we have this issue resolved and we should be fine for the full year.

So we've had an eventful quarter. Some things we knew about; some things we didn't. With the exception of the warranty adjustment, these first quarter events should have a minor impact on our full year objectives.

I'll let Dan take over now and put the remainder of 2012 in context.

Daniel C. Ustian

Yes. Thanks, A.J. If you turn over to Slide 8, I think A.J. identified it properly. We're going to be a little more granular today about how we get to the objective of somewhere around $5 a share.

So if you look at the bottom of Slide 8, you can see our guidance is $4.25 to $5.25. I do want to point out, that as A.J. pointed out, from last year to this year, there are 2 things that are different. Postretirement has increased by about $100 and the tax rate has increased as well. The total effect is about $2-a-share difference from a nonoperating basis, $2-a-share difference from year-to-year. So essentially, if we didn't have those, the $5.25 guidance would be $7.25 on an apples-to-apples basis from last year.

But what we'd like to focus on now are 5 items, how we make the $4.25 to $5.25 guidance that we have. And A.J. has -- so they're listed on here: warranty, volume, cost reductions and our global business. And we'll go through each one of those. But let me start with just adding one more thing to warranty. And that is we expect to get a lot of this back. We'd like to get it all back over time. But for this year, we think the opportunity is to get about 1/2 of it back. When you look at the cash impact of that in the first quarter, it was a small number. It was $3 million. So what A.J. said is the model reacts quickly to that, which hopefully also means when we put things in place and we lower this, which is what our intentions were to begin with, that, that will come back to us. So we believe there's an opportunity to get 1/2 of that back this year and hopefully, all of that back over the next couple of years.

So let's turn over now to Slide 9 and talk about U.S. and Canada charge-outs. And this is similar numbers, if not identical numbers, to what we showed on Analyst Day. You can see a trend in our company is always -- it's back-end loaded in terms of volume. There are many reasons for it. Some of it is seasonality for us, our customers' operating days. But you can see the trend here is that Q1 is always the lowest. Q2 is kind of average and then the back end of the year is higher. So this would illustrate a normal-type industry and our segment shipments for us.

In the North American side, let's talk about margins a little bit. This is totally for North America at this point. Our cost reduction program in Q1 and Q2 was -- our program was basically a carryover from cost reductions we had in place as of last year. In the second half of this year, we have over $100 million identified and actions in place to improve our margins on our North American business. And for those of you that visited with us here at our engineering complex in Lisle, you saw some of the ways that we're going to do it through cost reductions on product, but also synergies that we have in combining all of our operations into one place. And that will take place this year yet, and we'll get a $100-million benefit from that.

On the engine side, big bore diesel in particular, in Q1, we were transitioning over to making our own castings. So what happened in the quarter was a significant number of airfreight went on in the quarter. And we also started up our foundry to make these castings, so we wouldn't have capacity issues with the supplier that was doing that. And in the quarter, it was $15 million to $20 million, most of it excess freight but some of that was startup. That is mostly behind us now. There's a small amount still left. But by April, all of that is behind us. And in the last half of the year, we'll get the benefits of all that, which is close to $1,000 per engine lower in cost on our big bore diesel as we go into the last half of the year.

In South America, this is a business that -- this is diesels now, South America engine business. This business is about $1 billion a year and we have anywhere between 7% and 10% profits on this, year in and year out. It's typical for us in the first quarter to be lower than that because Brazil is down in the entire month of December. And this year, as A.J. pointed out, we also had lower volume from a particular customer who had his own supply issues. So for the quarter, in South America, we had a loss of $14 million. For the year, we're still going to be at that 7% to 10% margin. So this will come back over the next 3 quarters and we've shown this, through every year for the last several years, that this is doable and we will accomplish that again this year.

We look to the global truck markets now on Slide 12. We've broken it into 3 categories. First is Latin America, and this is our mature market. Our dealers have been there. Our products are in place. Our cost structure is right, and we're making money on this to the tune of our 10% segment targets.

In the rest of the world -- and we've got a typo on here. This is India, South Africa and Australia, the products are in place. The distribution is growing and this is kind of a buildup over the next couple of years to where we get this to where we want it to be.

The final one is Brazil. And this is a start-up year for us in Brazil, where we're just putting in products. We're just getting the distribution in place, so there's some investment going on in Brazil. And that's the 3 areas. I'll talk some more about this at the end.

But in Q1, we had a loss of $16 million. We expect the full year to be 2% to 3% return on sales and that's on $8.5 billion worth of revenue. We know we have actions in place for that. One of the areas operationally that hit us in the quarter was some engine supply constraints that A.J. already spoke to. We have those addressed through substituting a different engine in some cases, and our supplier is also increasing his capacity, so we feel we'll get that back by year end. And we'll be back on the 2% to 3% return on sales that we had targeted.

If I may ask you to now go back to Slide 8, as a summary here. As you can see from the actions that we have in place, we are clearly back-end loaded. This is not unusual for us, to have more of our income and revenue in the back half of the year. We have actions in place to be able to do that. And those are the 5 major categories and actions that we have to reach those objectives of $5 a share by the year end.

So I'd like to take a moment now and then talk about some strategic things that we're also doing during the year. And certainly, the product development center that we have here in Lisle is at the cornerstone of that.

And if you look at Slide 14, what's going to happen this year is we're going to implement our feet first strategy. And what that means is we're going to take assets that we have, maybe not directly trucks, but in other businesses like our engine business or in our bus businesses to get into the countries with our feet first and use those assets that we have to grow our truck business. So this year, our engine business will be in China and our bus business, we are working to try to get into China. And in South America, we'll be there for sure. So we call that our feet first strategy. We'll start in there this year. The benefits of those will actually take place towards the end of this year and into next year.

On the defense side, this is a business that we've had consistent $1.5 billion to $2 billion worth of revenue. This year, a big -- a game changer for us is taking our MRAP product and lightening it up. So it's a mine-resistant vehicle, armored, with about 1/3 of the weight and 1/3 of the cost. And so hopefully by the end of the year, we'll find a home for this for the future. We're not anticipating that we get business with this or much significant business with this, this year. But we're hoping to land this for the future in this year and it certainly, we believe, provides our customers with a significant opportunity to lower their costs and provide the same level of survivability.

Now I'd like to shift a little bit to Slide 16 and talk about a business that we've entered recently, and that's natural gas and perhaps some of you have seen the partnership that we've established with Clean Energy -- and that's Boone Pickens on there, and with Clean Energy and Chesapeake.

And so the first question you might ask is, "Okay, now why does this make sense for you?" and that's on Slide 17. Well, first of all, the economics, and we'll show you that in a minute here. The economics make a lot of sense. We believe that natural gas can stand on its own without subsidies for our customers and of course then for us. So it has sustainability without subsidies. We also have breakthroughs and technologies on the gas extraction side and of course, in our own engine emissions and of course, in our integrated product as well. So we believe this is a sustainable business and we're investing in it with some partners and you're going to see this grow over time. I'll talk a little bit about what we expect from that as it matures in a minute here.

But if you turn to Slide 18, this shows you illustratively why this is going to work. With an initial investment for our customers -- now this $25,000 to $40,000 is above the normal vehicle price. $25,000 to $40,000. With our arrangement with Clean Energy, our customers can get that back over 5 years. They can get it all back over 5 years through discounts that they get from Clean Energy, if you buy our truck and Clean Energy fuel.

In addition to that, this is the fuel savings that they get, and we believe this is modest and conservative. You can see from here, it's a tremendous opportunity for customers that can use this in their applications to get -- drive their operating costs a lot lower.

And of course, on Slide 19 is why we believe our answer is best than anyone that's out there. I mean, it's an integrated platform. We have an integrated solution with our engine; with our vehicle; with our partner, Clean Energy; and with a strong distribution network. So we believe over the next couple of years, this commercial industry will be -- 20% to 25% of the total buy could be in natural gas products. And we'll be at the leadership of that.

Okay. So let's go to Slide 20. And this is a kind of a building block of our engine strategy. But first of all, an integrated platform, one that we started off by converting the industry from 15 to 13 liter. And the advantage goes to fuel economy and weight. But for us, it's also a steppingstone for our dealers to sell more parts and service more products. And of course, us to get some growth in the profits from a good business like the service part provides.

It also provides our engine business with volume and technologies to grow their business and to be a player throughout the world. I've also mentioned that it's an enabler for us in our feet first strategy to get in some countries that are looking for technology, and particularly in this area to meet emission.

And I'll give you one of the examples of that. We have entered China now. And with that, we have a 3-liter and a 5-liter engine in there that meets Euro IV, the only one that meets it without the need of urea-based after-treatment, the NOx. We'll be the only one in that area as well and that's implemented already. And as I mentioned earlier, it's a platform for alternative fuels as well.

So if you look at Slide 21, now this is a summary of the year as we've described here and we'll tell you what's in it. So if you look at the right-hand side, it says our guidance is $4.25 to $5.25. And a couple of things are in it.

First, I mentioned, we anticipate recovering some of that warranty. $50 million to $60 million of that warranty, we expect to recover back. So it's still an increase here of $50 million to $60 million above what's in our original guidance. We've also included $25 million for NCPs and here's why, which is somewhat different than what we said on the Analyst Day. And the difference is this: there was a lot of noise out there about how long these NCPs would last. So what we did is in the 10 states that require no NCPs, we're going to use credit for those, and the 40 states, we're going to use the NCPs. So that should take us through the year to try to quiet down the noise of the uncertainty that some have had out there about whether we can ship products. So we feel this is the best answer for us for this year. And we've included in here $25 million worth of cost in our guidance.

Now one other point I would like to say. I mentioned earlier that we're going to get more savings in the back half of this year related to our new facility here. And it's uncertain as to where that's falls. Does it in segment? Or does it fall in SG&A? So this is an estimate of where it falls. It could change a little bit between SG&A and in segment but that doesn't change where we think the guidance should be, but it may change between segments and our support.

So let's talk a little bit about that integration. We said this facility here would save us $60 million directly and then the benefits, of course, are far greater than that in the product and in other areas. Now we believe that's more like $100 million. And so that's just direct savings of it. Again, we'll start to see that about midyear this year. And the ongoing part of that will be $100 million going into 2013.

So stepping back now. Remember on Slide 23, our objective was to be a $20-billion business when the economy was average and the trucking industry was about 350,000. We said at that point, we would be a $20-billion business and we'd have about 9% segment profits or $1.8 billion. So now let's talk about where we're at to those in terms of actions.

So completed actions are bus, military, Latin America and parts. Those are done. All the actions are in place. By the end of the year, we believe the actions are in place for North American truck, for engines and now natural gas as well. We still have more actions to put in place and probably more time in the global business, both in truck and bus. But in the rest of the businesses, by the end of this year, all the actions will be in place for us to achieve those targets.

So with that, A.J., I think I'll turn it over to you.

Andrew J. Cederoth

Thanks, Dan. We talked back on Analyst Day on the importance of expanding our margins and improving our cash flow in order to sustain the investments that lead to our strategic success. This is where we have our businesses focused primarily on margin expansion and cash flow.

So let's start with cash flow. We ended the quarter with manufacturing cash of $837 million. As you may recall, we had to stop shipping trucks late in the quarter. This caused us to end the quarter with slightly more inventory than we expected, but we've resolved these issues and trucks are now flowing normally.

For the full year, not much has changed. We recognize that there's been some adjustments to cash from operations. But like warranty, most of these are noncash items. Similar to income, however, the cash will remain relatively flat through the first couple of quarters and then recover in the second half of the year.

To improve upon our cash flow, we continue our efforts to reduce the level of working capital we deploy in our business. While not yet developed well enough to incorporate into an official forecast, we have challenged each business to reduce their working capital needs, which would enable us to close the year with a cash balance beyond $1.2 billion.

To close, I'd like to build upon Dan's discussion on margins, particularly our efforts to expand on these margins. As we've stated, our strategic plan is to expand our business to $20 billion of revenue. And when we do this, generate 1 point billion dollars (sic) [$1.8 billion] of segment profit for a blended return on sales of 9%.

We've organized the chart on Page 25 to show the path that each of our businesses is on to achieve our strategy. You can see here that we've incorporated service parts into the businesses because as we grow our truck and engine businesses, we create the opportunity to expand our parts business. We believe we have the business on the right path. When we normalize 2012 and look at the run rate of the business by the end of the year, you can see the results.

Throughout this presentation, Dan's focus has been on the elements of the business that lead to strategic success and improve our margins. From our focus on integration and streamlining our organization by leveraging this new building; to expanding into new markets like natural gas and further leveraging the opportunities within our defense business; and finally, and I believe most importantly, by expanding our product offering, both domestically and globally, to get closer to the customer and to continue to expand our margin. I believe these are the differentiators that we have and that these will drive success in our business and ultimately lead to strategic success.

With that, Heather, I think we're ready to field questions.

Heather Kos

Operator, we're ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll hear first from Andy Casey with Wells Fargo Securities.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

First, thanks for the clarification on the $25-million NCP hit. Dan, could you -- or, A.J., let us know how many months you're assuming the NCP payments continue for that $25-million hit?

Daniel C. Ustian

Yes. So, Andy, here's a -- maybe a way to look at it. We've submitted the -- for the 0.2. And that goes through a process and typically that's about 3 months, I think, is about the average of that. So when we get the certification, it still takes some time for us to get to production on this. So what we're doing right now is getting ready to go to production in that, and it will be about June before we can get into production with that particular engine. So that -- it kind of gives you a framework of where it would be. The preciseness of it, we can't tell you, but our objective is to begin production on that in June.

Andrew M. Casey - Wells Fargo Securities, LLC, Research Division

Okay. And then if we look at these warranty issues that caused the charges, can you kind of give us a little more detail, so we can make an assessment on why these may or may not impact field performance of your ultimate solution for EPA 2010 at the 0.2 level?

Daniel C. Ustian

Yes, yes. First, let's break it into 2 categories. I think the first one is those are -- the half of it is from old products. And those are things that we had assumed we had repaired. We had all those fixes in place and -- but the trends didn't come down like we had expected. So obviously, we didn't fix them to the level that satisfied our trend rate, and so that continues. The other ones were -- we went out in the field and were more proactive on it and it increased our trend rate because of that. And what we need to do now is to prove that those fixes are in place and that trend rate will come down, both from a -- as A.J. points out, from a frequency standpoint and from a dollar standpoint. So we believe they're all in place. These are from '10 -- early '10 products. We had an opportunity when we found that our customers, their utilization of their vehicles are less in the December month, so we went after them with aggressiveness to try to get at them during periods when they wouldn't be running as much. And we did that, but what it did do was increase the trend rate on that. So that also gives us the confidence that we can bring it down again.

Operator

And we'll continue onto David Leiker with Robert W. Baird.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Dan, did you say the actual cash cost to execute these warranty changes in the quarter, that was the $3-million number? Did I hear that correctly?

Daniel C. Ustian

Yes.

Andrew J. Cederoth

David, it was a $3-million increase from what we expected.

Daniel C. Ustian

Increase from the trend that we had before.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then if...

Daniel C. Ustian

Someone just slipped me a note here and these -- we've got all of the Vs and the inline DTs and we haven't had any issues since the '06 and '08 one I just talked about there. So these '10 engines are running the best they've ever run. It's that in the early on '10, there were some minor things that caused us to go back and repair them, and much of them were in calibration.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Great. And then can you detail specifically what components, what parts of the engines that you're having a warranty issue with on those engines?

Daniel C. Ustian

I think when you get into these things, everything is so electronically controlled that when you do a calibration on it, it could affect whether the performance of any part of that engine works or not. And when you have, how many different -- I've got Jack Allen here. We have so many different variations that the electronic controls have to be able to adapt to each one of those. And we had -- we took some time, several months, before we got all those things in place on the control side. So it's more of a system thing, I think, Dave, than it is a part thing.

Jack J. Allen

Not specific hardware.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Right. Not specific hardware, right.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Okay. And if you go over the next several months or so and you wait for this -- the cost trend to start to improve from these actions, what's the timeline on the other, as to being able to see that? Are those weeks? Are those months? Quarters? How would you characterize that?

Daniel C. Ustian

Let me -- so we understand what it is. So the ones going out the door for the last year, that -- those are done [indiscernible] we're talking about the ones that are already out there. So what's accounting does -- and I'll ask A.J. to chime in here, but I've had enough study of this. It's not like I don't know. And that is -- the accounting has to have the experience on the frequency of repair and the cost of those repairs. You have to prove it before you can bring this back out again. And we think it will take us until -- certainly won't happen in the second quarter. I think that's no question about that. It's going to be in the third or fourth quarter before we're able to get that back.

David Leiker - Robert W. Baird & Co. Incorporated, Research Division

Okay, great. That's exactly what I was looking for. And then one last item. If you hadn't seen that boost in the warranty reserve, it looks like you would have been in a position potentially to have raised your guidance. Is that the right way to look at that or not?

Daniel C. Ustian

We probably wouldn't have. But I would say, we wouldn't do that. We wouldn't have done that, Dave. I think we would keep it at the same level that we're at right now. And I understand your question. I think it's probably appropriate that we've found ways to overcome some of those things out there, but we wouldn't have raised our guidance.

Operator

We'll take our next question from Jerry Revich with Goldman Sachs.

Jerry Revich - Goldman Sachs Group Inc., Research Division

I'm wondering if you could talk about the comment you made in the Q about material cost outpacing pricing in the truck business in the first quarter, and just help us get a sense for when pricing is going to meet or exceed material inflation over the balance of the year. How does your contracted pricing and product out the door look from here?

Daniel C. Ustian

I'm going to ask Jack here, but just to frame it now what that means, Jerry. That means that -- remember last year, we had pricing before we had the commodity increases because we had those hedges on it. Now the hedges are off or less and so the commodity costs are going up. So, Jack?

Jack J. Allen

I mean the best way, I think, to describe it is, we have escalators with many of our customers relative to material costs, but they have lags built in with them. And now as commodities costs are hitting us relative to a year ago, as Dan said, primarily because we don't have the hedges. There's just a natural lag before we collect that in the marketplace on pricing. But we certainly have built into our plan, to catch-up on that as the year progresses.

Daniel C. Ustian

So I think somewhere, maybe we have it in the package. I think we have that it has -- it's really stabilized for the last several months now and our fuel is up a little bit now. But commodities have stabilized now for several months.

Jerry Revich - Goldman Sachs Group Inc., Research Division

And so as you look at your remaining hedge book and your pricing schedule to customers on a year-over-year basis, Jack, when do you expect pricing to exceed material inflation? Which quarter or -- would you just give us a rough sense?

Daniel C. Ustian

Well, I think, Jerry, the way Jack described it is the best way to look at it, is that pricing will escalate throughout the year. There's never a perfect match between material cost movement and hedge movement and pricing action. So our plans are to recover that in the second half of the year.

Jerry Revich - Goldman Sachs Group Inc., Research Division

Okay. And, Archie, if you're on the line, can you comment on the timing of the rolling chassis program? When is it looking like you'll get to work on those products? And also touch on the softer parts sales in the quarter. Anything timing-related that drove the significant decline?

Archie Massicotte

Yes, Jerry. We're in production on the rolling chassis as we speak. We've already made our first delivery. We just acquired a contract to do the retrofitting of the body on the chassis at West Point. That contract was just over the wall as of last week. So that's ongoing and as you know, that's got a leg to it to go into 2014 -- or '13, rather. The parts side of the house, we're actually seeing an incline right now on parts sales. It is more so related to some of the earlier trucks that we had out in the field in Afghanistan and Iraq. And there's some new stuff going and I don't have the full order yet, but it's showing positive impact. Again, on the sustainment of everything we put in the field is really holding up well. And that business, as you know, we've turned completely over to the sustainment side. And that's starting to show pretty good results.

Operator

We'll take our next question from Ann Duignan with JPMorgan.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

Can you talk a little bit about the impact of these higher warranties on residual values for your used trucks? And then secondly, could you talk a little bit about 15-liter to 13-liter? You've only submitted a 13-liter for approval to the EPA. Does that mean you're giving up on the 15-liter? And we look at Cummins in the last couple of months and it's gaining share, engine share, suggesting that customers are still specifying 15-liter engines out there. So sorry for the lengthy question, but if you could just kind of hook the 2 of those together, I'd appreciate it.

Daniel C. Ustian

Sure. And I'll ask Jack to answer those. Go ahead, Jack.

Jack J. Allen

Maybe one at a time. Used trucks clearly -- our ProStar continues to have excellent used truck residual values. The issues that we have described here, we're addressing them with the customers and we're addressing them in the deals. And therefore, there's really no impact to used trucks or calibration. We're fixing the calibration on them. We continue to see excellent used truck values. Regarding the submission, I think, was your second question. We submitted the 13-liter. We're prepared to submit the 11 and 15, Ann. I'm not quite sure why you would jump to the conclusion that we're abandoning it, but we're prepared to submit the 11 and 15. But it really doesn't make a lot of sense to do that until the EPA addresses the 13-liter and we can work back and forth with them, and then we'll follow on with the 11 and 15-liter. I'm sure you see the trend reports like we do. In 2011, 13-liter has crossed the threshold, 15-liters, and there's now more 13-liters sold in the marketplace today. And we believe that as one of our major competitors has a more free supply of their own proprietary engines in 2012, you'll continue to see the trend of 13-liters grow in the marketplace.

Ann P. Duignan - JP Morgan Chase & Co, Research Division

So you have no comment on the fact that Cummins' 15-liter is gaining share in places like Freightliner and Volvo?

Jack J. Allen

I think you got to just go back to the comment that I just made.

Daniel C. Ustian

Ann, I think he's saying that there's some capacity constraints with some of our competitors on their own 15-liter and 13-liter right now.

Operator

We'll take our next question from J. B. Groh with D.A. Davidson.

J. B. Groh - D.A. Davidson & Co., Research Division

I think this maybe plays a little bit on Ann's question on share. But can you -- on Slide 27, I noticed a little bit -- market share down a little bit. And I'm guessing that there's an impact from maybe some delays on the shipments in Q1. Can you sort of -- is there a way to quantify or maybe just give us an indication of why that's down and where you think it's going?

Jack J. Allen

Well, salvage certainly is the Bendix shipment [ph] related at the end of the quarter. But in medium-duty, we had a big run-up the last half of the fiscal year last year, where we were trending way above 40%, which is above what our norm is. And that was driven by some big fleet sales as well as our fiscal year end, and we had some fewer year-end programs. So it wasn't really totally expected for us to see that fall off as the year began because competitors had their own year ends in December. So a number of things happened in the quarter. We replenished the stock inventory in our dealerships, so that hasn't rolled through to retail market share. Some fleet build that we traditionally would have had in the quarter has moved out to the second quarter and then a little bit of the Bendix issue. But just to give you one bit of data here, as we look at February. So it's not in the quarter but we have the information for February. On medium-duty, our retail deliveries in February for medium were 31% higher than our average monthly rate in the first quarter. So we're seeing the recovery that we had expected.

J. B. Groh - D.A. Davidson & Co., Research Division

So you got a combination of a little bit of a tough comp from last year and then some of the stuff that we mentioned about the delays?

Jack J. Allen

Yes.

J. B. Groh - D.A. Davidson & Co., Research Division

Okay, okay. And then can you talk about maybe driver shortage and how that's -- you think that will impact customers? It's kind of an interesting dynamic.

Jack J. Allen

Well, it is pretty amazing that in this era of unemployment that driver shortage has continued to plague our customers. But we spent a number of days with them this past weekend at the Truckload Carrier Conference. We talked a lot about drivers. I think the biggest thing you're going to see here and that they're seeing is that driver pay is progressing. And they're willing to pay drivers for productivity and drivers that are doing a good job for them. So we'll continue to see driver pay increase. And frankly, fleets are -- they're pressuring us around driver amenities and appeal and uptime for the drivers, so they can be profitable [ph].

Operator

We'll hear now from Patrick Nolan with Deutsche Bank.

Patrick Nolan - Deutsche Bank AG, Research Division

Just a couple of follow-up questions on the warranty and then a question on military. So just so I interpret it right, so you are factoring in that you do get $50 million to $60 million of this warranty charge back in the back half of the year. That's incorporated into the full year guidance.

Andrew J. Cederoth

Yes, that's correct.

Patrick Nolan - Deutsche Bank AG, Research Division

And so it sounds like most of these warranty issues are all engine calibrations. I mean, is it reasonable to assume that as you launch out the 0.2 engine, that there's potential for this to reoccur?

Daniel C. Ustian

Well, I think that's a good question, Pat. This is why we're taking until June to go to production with it, so that won't happen. But I think that's a fair question, and we're doing the actions to prevent that from happening.

Patrick Nolan - Deutsche Bank AG, Research Division

And just on those early 2010 engines, I mean, what's the average mileage of those engines that are out in the field now? Because I mean, I would assume a lot of the Advanced EGR concerns that people have would be when you're at the higher end of mileage for engines as far as additional heat and the impacts of that.

Daniel C. Ustian

The early ones probably have a couple of hundred thousand miles on it. The things we're talking about are really kind of input things, so not mileage-related. That's probably the ones that are very early, there's a couple of hundred thousand miles on it.

Patrick Nolan - Deutsche Bank AG, Research Division

Got it. And could you give us some color on what the cadence of military revenue is going to be for the remainder of the year?

Daniel C. Ustian

Yes. I think, it's going to -- we said it's $250 million. I think the question earlier was -- so it was about $250 million in the first quarter. And I was anticipating and I think we'll be probably be a little higher in the second quarter. Archie, what [indiscernible]...

Archie Massicotte

Well, the revenue -- as you know, we have a schedule for rolling chassis that are going through the system. And we are kind of regulated, by schedule, how many we can produce per month. I mean, there's a flow that has to be consistent with what they can take and so that's governing a little bit of what our revenues look like. But for guidance, for the year, I mean we're still marching towards the $1-billion to $1.5-billion range of guidance for military. Now how that comes in quarter-over-quarter, it again -- it will be more heavily loaded in the fourth quarter but that's just the way the business is.

Andrew J. Cederoth

I think -- Pat, this is A.J. I think the -- when we look at that, I think military revenue was lower in the first quarter this year versus last year, and it will be lower in the second quarter versus last year as well.

Daniel C. Ustian

But we said the whole year is going to be less.

Andrew J. Cederoth

Right. Around $1.5 billion.

Operator

Tim Denoyer with Wolfe Trahan.

Timothy J. Denoyer - Wolfe Trahan & Co.

Quick question on the -- actually this is a follow-up on the military guidance. I thought that you had said $1.5 billion for the year. I thought -- was that new, the -- what Archie had just said, in terms of $1 billion to $1.5 billion?

Daniel C. Ustian

No, our guidance is based on $1.5 billion of military revenue.

Timothy J. Denoyer - Wolfe Trahan & Co.

Okay. And then another question just sort of on the medium duty market overall. You said things are picking up there, but just looking at the order trends over the last couple of months, it seems like medium duty has sort of taking a little bit of a step back. Are you seeing that in terms of your order trend in terms of heavy duty maybe outperforming medium right now?

Jack J. Allen

Well, certainly the growth rate in heavy on a year-over-year basis is more than medium. But medium-duty market has some really -- some good increases also. But medium-duty market today is really heavily influenced by some large fleets and primarily it's on the leasing side. But -- so that medium tends to be more choppy from an order received rate and even from a share standpoint. In the first quarter, there was 16,000 deliveries. So 1% market share swing happens over 150, 160 trucks. You'll see a lot more choppiness in medium duty.

Timothy J. Denoyer - Wolfe Trahan & Co.

And then one other question, on natural gas actually. With one of the slides that you showed in the sort of cost-benefit economics, do you imply that the customers would be getting sort of locked-in CNG prices over a multiyear period with Clean Energy?

Daniel C. Ustian

I'm going to ask Eric Tech. He's in charge of our engine business. Eric?

Eric Tech

Yes. That's one of the potential. There's a lot of different ways our customers can benefit this -- from this. They can stabilize their fuel costs over several years, they can lock in to the Clean Energy program or they can just play on the spread between the 2. So we're looking at developing the right solutions for our customers depending on what fleets we're selling to and depending on their circumstances. But clearly there's a huge spread there and an opportunity for them to reduce their operating costs.

Timothy J. Denoyer - Wolfe Trahan & Co.

Yes. And at what point do you expect to introduce your own engine into the natural gas market? Was that '13 or '14?

Eric Tech

We are currently producing a DT engine for medium trucks. And we're looking right now at introduction of a big bore engine sometime in the next 1.5 years.

Timothy J. Denoyer - Wolfe Trahan & Co.

Okay. Is the DT at any significant numbers in terms of CNG?

Eric Tech

Yes. Right now, we're really -- we're in the 100s and we see a large ramp-up as really we see now the interest that we've garnered on this natural gas play. And we really see the numbers ramping up through the end of this year. And really -- probably the impact will be more real in the next year than 2013.

Operator

We will continue on to Andrew Kaplowitz with Barclays Capital.

Vlad Bystricky - Barclays Capital, Research Division

This is Vlad Bystricky on for Andy. First question. Can you just talk about, on the warranty issue in the quarter, how is that impacting your dealers? Is it an additional cost or additional work for them? And is that taking away at all from some of the training that you had talked about at your Analyst Day, related to rolling out more of your own engines?

Daniel C. Ustian

Jack, go ahead. Why don't you answer that?

Jack J. Allen

Well, the dealers have worked together with us and the customers in a partnership here to address the actions primarily that we took over Christmas. That's really the big driver here that we're talking about on this morning's call. So during this period of time, the customers would typically -- their vehicle utilization is down over those holidays and also, the dealerships have more availability during that period of time. So together -- we put our resources within the company together with the dealers and customers to address the customer concerns in that period of time. It worked out very well from a customer satisfaction and an upside standpoint.

Vlad Bystricky - Barclays Capital, Research Division

Okay, great. And then just thinking about your customers. We talked about the driver shortage and impact of rising driver wages. Can you talk about gas prices? Obviously, we've seen an increase there, and what are your customers saying about that? When does that start to be a concern for them? Are they able to pass on those prices now? Or when might it affect their buying decisions?

Jack J. Allen

I think it's -- a lot of that depends on different segments of the business. I'll take it, if you're really focused on Class 8 here, most of the large fleets today and the shippers have a formula that they've used for some period of time now called fuel surcharge. And it allows the fleets to vary their rates to the customers on an ongoing basis, very variable, depending on what fuel prices are at the time the load is delivered. So it's a -- rising fuel prices are never a good thing for our industry. But at the same time, our customers have a mechanism under which to recover that. But at the end, it really does focus back on us. And the more we can do to provide a great fuel-efficient truck and engine, integrated solution, that's what our customers are looking to us for.

Operator

We'll take our next question from Seth Weber with RBC Capital Markets.

Seth Weber - RBC Capital Markets, LLC, Research Division

Just wanted to go back to the accrual adjustment for a second. The 45% attached to the '06, '08 time frame, was that the same adjustment that you took in the second quarter of last year for the same -- is that the right way to think about it?

Andrew J. Cederoth

Yes, it is, Seth. As Dan said, when we put that adjustment in last year, we thought we had the right trend and we expected that to perform according to that forecast and it's continued longer than we expected.

Seth Weber - RBC Capital Markets, LLC, Research Division

Okay. And if I remember, that was basically an injector problem or something like that. Is that correct?

Andrew J. Cederoth

Right.

Daniel C. Ustian

That's correct.

Andrew J. Cederoth

Mostly related around medium-duty engines.

Seth Weber - RBC Capital Markets, LLC, Research Division

Okay. And then just a clarification on the outgoing run rate margin targets that you put up. So for the engine business, the 7 to 8. So that includes the $50-million to $60-million add-back for the accrual, then?

Andrew J. Cederoth

Yes, we've -- I mean we've taken the accrual adjustment out of that, so that we can look at the business on a run rate basis.

Seth Weber - RBC Capital Markets, LLC, Research Division

Sorry. So just -- that does not include the add-back at the end of the year that you expect?

Daniel C. Ustian

Well, no, no.

Andrew J. Cederoth

No. It doesn't include the add-back. It doesn't -- also, it doesn't include the charge. We're kind of viewing the charge for warranty as a onetime item.

Operator

And Robert Wertheimer with Vertical Research Partners.

Robert Wertheimer - Vertical Research Partners Inc.

I'm still trying to figure out how to isolate or evaluate the 15-liter side. And I'm wondering if you could say if the issues were specific to a particular production run or a particular production date or engines that underwent a particular calibration. You mentioned you went out to customers with a fix. And I don't know whether -- how you identified those trucks that you went out to, those engines that you went out to, and whether you've gone out to all the ones you've identified yet.

Daniel C. Ustian

So that's sort of the early 13-liter, I don't -- if we said 15-liters, we didn't mean...

Robert Wertheimer - Vertical Research Partners Inc.

I'm sorry. That was my fault. I beg your pardon.

Daniel C. Ustian

Okay. So these were early 13-liter vintage that we went out and did some calibration to get these different -- various different repairs [ph], sometimes in signal, sometimes in operations. We went out there and tried to get at most of those or all of those during the holiday period here.

Robert Wertheimer - Vertical Research Partners Inc.

So the final calibration...

Daniel C. Ustian

The production side of that is in place and it has been in place for quite some time now.

Robert Wertheimer - Vertical Research Partners Inc.

Okay. So the final calibration, you're pretty confident, is not causing issues. It was an interim calibration that caused an issue with component failure. I'm just trying to understand that part.

Jack J. Allen

It was the calibration that was in effect at the time those vehicles were built back in 2010. We subsequently updated those vehicles with current production calibrations and that's alleviated the issues that were present at that time.

Robert Wertheimer - Vertical Research Partners Inc.

Okay. And so you have not seen any issues with trucks that were shipped under the final production of the current calibration.

Jack J. Allen

The vehicles that we're putting in the marketplace right now are performing to our expectations.

Robert Wertheimer - Vertical Research Partners Inc.

Okay. And then just one quick question, A.J. It was a little surprising to see this issue pop up after you have listed the few issues that could have affected the quarter, and this wasn't on it. I assume it's because that $3-million ramp over trend was just something you hadn't spotted as of February 1. Is that why it came in after the quarter?

Andrew J. Cederoth

It came in after the quarter because it does take us a little bit of time and it takes a lot of analytics to truly understand the real impact of this type of an adjustment. And we didn't have that information clearly understood on Analyst Day.

Operator

And, ladies and gentlemen, that's all the time we have for questions today. I'll turn things back over to our speakers for any additional or closing remarks.

Daniel C. Ustian

Okay, thank you. Of course, Heather and Randy will ask any questions -- answer any more questions that anyone might have, and we'll get back with you if you have any further questions. But thanks for joining us here this morning.

Operator

Thank you. Ladies and gentlemen, that does conclude today's conference. Thank you for your participation.

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