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Navistar International (NYSE:NAV)

Q3 2012 Earnings Call

September 06, 2012 10:00 am ET

Executives

Heather Kos - Vice President of Investor Relations

Lewis B. Campbell - Executive Chairman and Interim Chief Executive Officer

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

Troy A. Clarke - President and Chief Operating Officer

John J. Allen - President of North America Truck

Archie Massicotte - President

Analysts

Henry Kirn - UBS Investment Bank, Research Division

Jerry Revich - Goldman Sachs Group Inc., Research Division

Stephen E. Volkmann - Jefferies & Company, Inc., Research Division

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

Robert Wertheimer - Vertical Research Partners Inc.

Brian Sponheimer - Gabelli & Company, Inc.

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

Michael Shlisky - JP Morgan Chase & Co, Research Division

Timothy J. Denoyer - Wolfe Trahan & Co.

Vlad Bystricky - Barclays Capital, Research Division

Operator

Good morning and welcome, everyone, to the Navistar International Corporation Third Quarter Earnings Release Conference Call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the program over to the Vice President of Investor Relations and Financial Communications, Heather Kos. Please go ahead, ma'am.

Heather Kos

Good morning, everyone, and thank you for joining us for Navistar's Third Quarter 2012 Conference Call. With me today are Lewis Campbell, Navistar's Chairman and Interim Chief Executive Officer; Troy Clarke, our President and Chief Operating Officer; and A.J. Cederoth, our Chief Financial Officer.

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 non-GAAP financial measures discussed in this 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 safe harbor statement and other cautionary notes disclaimer presented in today's material for more information on the subject.

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

Lewis B. Campbell

Thank you, Heather, and good morning, everyone. Many of you know me from my days at Textron, and I'm really looking forward to working with each of you again. I am probably new to most of you, however. So I hope to get out in the next month or 2 to meet as many of you as possible.

Probably on your mind this morning is you're probably wondering how I landed here at Textron -- Navistar. I knew I'd say that. I've only been at Textron for almost 18 years. So I'd like to take a moment to explain.

After retiring from my former company, I recently received a call saying that I was being considered for the job here at Navistar. I was obviously very surprised to get the call, but I was very intrigued by the opportunity to join what I believe to be a very important American icon. You know there are not many times in life that you can come into a company with such a rich history and have the opportunity to help a great team shape the future in an important way. So after a lot of careful study, consideration and due diligence, I agreed to come onboard. And it's an honor to be given this opportunity. And you can be assured that I am and will continue to be 110% committed to Navistar, our leaders and our employees, our dealers and our business partners and, most importantly, to our shareholders.

My wife and I actually finalized an offer on a home here in the area over the past weekend. So as they say in poker, I am all in. Look, there's no doubt that we have as some would say some really big boulders in the stream. But as you can imagine, I did plenty of due diligence. And while there are a host of issues that need to be resolved, there was nothing I felt was unsurmountable when deciding whether or not to pursue this opportunity. In fact, regarding the issues we face, I was pleasantly surprised how well the experiences and sometimes scars I received at GM and Textron have prepared me to tackle the challenges we face. And on the positive side, what I learned in this due diligence process is that we have a strong management team with good operations, great products and a strong dealer network. I think we can all agree that Navistar is a great company. I believe that Troy Clarke is the perfect choice to be our President and Chief Operating Officer.

I was also pleasantly surprised when I got here to find out that Troy and A.J. and their teams had already begun work on each of the critical issues we face. And we are already finalizing a strong 18-month operating plan that we'll be putting in place throughout the balance of Q4, and I believe we'll have the proper metrics, including ROIC, put in place to help ensure our success. But I do believe we have to accelerate the pace of progress on the improvements needed so that we can quickly resume our rightful place as a profitable leader in the industry.

Let me emphasize that North American truck engine and parts are our core businesses. They will get the lion's share of focus for the foreseeable future. And while the fundamentals of the plan are there, we need to sharpen our focus so our plans become a reality.

I've broken down our plans into 6 key areas. First, improving quality. Quite simply, we need to step up the pace and address our problems as quickly as we can. Troy and A.J. will talk more about that in a minute, but basically, we have to be known in the future as the highest quality truck producer on the road.

Second, great products. This company is blessed with many great products. The ProStar is a phenomenal truck. You can be sure that we intend to continue to develop leading-edge products that will truly satisfy every one of our customers' needs.

But let me pause for a second. We had a great idea with our EGR-only emission strategy and while some would say we came very close, it didn't work out as completely as planned. Obviously, there are a lot of great trucks on the road today using that technology, but for the future, we know exactly what we need to do to implement our SCR-based clean engine transition. We're dedicated to hit each of our launch target dates. And we believe that as we begin to implement our clean engine strategy, we will begin to regain our rightful market share and eventually add to it.

Third point, we will be increasing our focus on customer satisfaction. Now there's already some great work underway here. As a matter of fact, the integration efforts at our new Lisle, Illinois campus has gotten people focused on processes that actually has a promise to yield possibly the best customer service in the industry. We also plan to rededicate ourselves to our dealers, our business partners and our customers. We know that when they're truly satisfied, winning is just around the corner.

Next, improving our cost. We need to get our costs in line with revenue with the central focus on return on invested capital. Volumes haven't been where the company or the industry thought they would be. But be that as it may, we intend to spend the next 2 months finalizing concrete plans to return to profitability as soon as possible. We know we need to lower our breakeven point, for example. We are almost complete with our voluntary separation program and reduction in force across the corporation. This is a bit early for us, but we have to step up the pace on other big cost drivers like material costs and discretionary spending, both of which I believe offer opportunity for much further improvement. A.J. and Troy will talk to you about these initiatives in more detail in just a moment.

Fifth, one of my favorites, instilling a sense of urgency. The faster we work on our problems, the faster we'll get them fixed. As you'll hear from Troy, we're launching a review of all of our businesses to evaluate their potential to drive long-term profitability and significantly improve our return on invested capital. In addition, by removing these initiatives that will not contribute to a strong ROIC improvement, the team has more time to spend on improving our core businesses.

And finally, people. I was so pleased to see that our people are becoming more engaged, energized and enthused as they do their work with perfect integrity. I've been out meeting as many people as I can this past 1.5 weeks, and I have to tell you that people at Navistar are top notch and ready to go. I am confident that with a clear plan and unbending leadership focus, they will help our leadership team deliver the results that I believe we're capable of.

To ensure that we stay focused on the right objectives and that we hold ourselves and our teams accountable for meeting these objectives, we have just announced this morning a formal senior and executive leadership structure. This will allow me, Troy and our other top executives to have much more regular and direct access to our plans, our commitments and our accomplishments going forward. And if we see an issue that's not on track, we will act with urgency and speed.

Let me emphasize one more point before I wrap up. We've been able to take I think one big question mark off the table. With the EPA final rule set to take effect in the Federal Register, we now have clarity on the transition to our clean engine strategy in 2013 which, as you know, includes a strong new business relationship with Cummins. We've been fortunate enough to have business relationships with Cummins for decades. Last week, I actually spoke with Tom Linebarger, the Cummins Chairman and CEO. During the call, we both fully committed to our SCR implementation timetable. And in fact, Cummins has already agreed to ship us 300 ISX 15L engines, 15-liter engines, in November for customer installation, and we already have customers lined up to buy those trucks before year end.

So let me conclude by saying we know we have a lot of hard work in front of us. We will be increasing our focus on the 6 areas I just mentioned, and as a matter of fact, any other area that we need to put more attention on to get us back on track. And we will be using return on invested capital to drive our decision-making process going forward. We already have many plans in place to remove the boulders out of the stream, but I'm sure more effort will be needed as we dig further into the details.

We do all this, with the full intention to increase shareholder value, not only for next year but for the years to come. In fact, I believe you will begin to see meaningful progress quarter-by-quarter beginning in our 2013 fiscal year. And as I said at the outset, I am honored to have the opportunity to be at this great company, and I will work tirelessly to see the time when all of you join me in recognizing our greatness.

With that, A.J.?

Andrew J. Cederoth

Thanks, Lewis, and good morning. The results for Q3 are in line with the ranges that we previously provided, so let's take a look at some of the details. Revenue for the quarter is $3.3 billion or 0.3 higher than our guidance. This was driven primarily by changes in mix. For the quarter, North American chargeouts were 18,600 units, which was driven primarily by lower industry demand and lack of recovery within market share.

Revenue from our defense business was $253 million. We remain on track to achieve our goal of $1.1 billion of revenue for the full year. Export for -- export volume of trucks was 3,000 units. The volume of exports is higher year-over-year but is below our original estimates, and the mix of vehicles has shifted from heavy-duty to medium. OEM engine shipments, primarily from MWM and South America, were 31,600 units, which is 11,000 units lower than our original forecast. The penalty for NCPs in the quarter was $10 million. Warranty expense for the quarter was generally what we expected. Spending was within the range of our estimate, and the frequency of repair data continues to track with our forecast. We did make a $28 million adjustment to prior-period warranty primarily related to fuel campaigns that we initiated. We also received a vendor recovery relative to warranty of $10 million, netting $18 million for the prior-period warranty expense within the quarter.

As you can see, we had a sizable adjustment to income due to taxes. This change is driven by lower overall income from jurisdictions like the U.S. and Brazil. In the second quarter, we estimated that the tax rate would be 4% to 5% for the full year. This was driven by our previous forecast, which had within it offsetting jurisdictional gains and losses. The impact of this dynamic was a low effective tax rate which was trued up in Q2. As the forecast has shifted, these offsets no longer exist, and thus the effective tax rate has increased, reflecting a more blended overall rate. This has been trued up in Q3. For the remainder of the year, you should use an effective tax rate of approximately 38%.

Comparing this year's results to last year, for the third quarter, revenue was lower by $200 million, resulting from lower North American chargeouts of 1,500 units, which is offset by increased pricing actions within North America of $26 million, lower OEM Engine deliveries of 10,300 units and lower defense-related revenue of $87 million. Year-over-year, the adjusted segment profit has decreased by $136 million.

Within our Truck segment, profitability has declined by $73 million after adjusting for non-GAAP items like engineering integration. This is driven primarily by lower defense revenue, which we previously discussed; lower contribution from our global business, primarily in Brazil and India; lower truck and bus deliveries within North America; higher product development expense; higher material costs not completely recovered through pricing; and offset partially by year-over-year manufacturing cost improvements resulting from our restructuring plans.

Within the Engine segment, profitability has declined by $66 million, excluding the impact of NCPs and engineering integration costs. The significant pieces to this are lower contribution from MWM, higher material costs, higher warranty costs and lower overall volumes within North America truck and bus.

Corporate SG&A is higher year-over-year due to higher -- to increased health care costs, which have been partially offset by cost reduction activities implemented during the fiscal year.

Let me take a minute to talk about NFC. Even though the profitability is lower year-over-year at NFC, NFC continues to have an excellent year. Portfolio quality is very good and available capital remains strong at $745 million. Recently, NFC completed several transactions in the market that have improved overall available capital, including a deal that supports the funding of exports through Bancomext in Mexico. We also renewed our wholesale facilities during the month of August.

Turning to Page 8, the parent company did complete the funding of the term loan facility on August 17, so we are showing cash on a pro-forma basis, and it included at the bottom of the page a forecasted range for year-end manufacturing cash of approximately $950 million. This shift in cash flow versus our typical fourth quarter is unusual. We do expect the softening in the North American market to continue. Thus, volumes will be lower in the fourth quarter, and this will have a negative impact on working capital of approximately $100 million. I believe the overall consensus is for the market to expand from these levels as we move into 2013. Thus, we should expect working capital to improve as volumes increase.

Within our defense business, we are finalizing the terms of our rolling chassis contract, which is taking longer than anticipated. While these vehicles will be delivered on schedule, collection of the receivable is likely to carry into fiscal Q1, thus consuming working capital in Q4. This has pushed approximately $100 million to $150 million of cash into Q1. As you can imagine, our team is laser-focused on finalizing the terms of this contract in order to collect this receivable as quickly as possible. If successful, some of these collections could be pulled forward into Q4 thus improving our year-end cash position.

With regards to our cost reduction efforts, we anticipate $50 million to $75 million of onetime cash expenses associated with our headcount reductions, which includes severance costs and other contractual obligations to occur in the fourth quarter. We have estimated that these cost reductions will save approximately $70 million to $80 million annually and are part of our overall plan to reduce our cost structure by $150 million to $175 million. When we step back and analyze where we are with cash, taking into consideration the current market dynamics, our restructuring actions, the shift in engine emission strategy and the corresponding transition plan, we believe we have adequate cash reserves to fund our business going forward.

In anticipation of the term loan, we developed multiple stress-tested scenarios in order to understand the impact on cash. And of course, the biggest driver of this is volume. Not only does it drive earnings, but it has a significant impact on working capital. With the revised Engine strategy and the shift to SCR, which includes the introduction of the Cummins 15-liter engine, coupled with the performance of our vehicles, we expect that our market share will recover and that we will return to profitability. But this will take some time. Until then, cash management will be very important. With that in mind, we are taking actions to improve our cash flow.

First, we have reduced our capital spending and have curtailed many investments, primarily within our global strategy. Second, we have reduced our SG&A and we will reduce this further going forward. Finally, we have redirected our product development resources to focus primarily on the clean engine SCR strategy and curtailed investments on other projects in an effort to reduce our product development spend. To summarize, we did anticipate this situation with our cash, that is why we added additional capital when we did. As you've noticed, we have not provided specific guidance on earnings at this time.

Precision around the industry volume remains uncertain. And as Troy will detail later, we are examining many elements of our business and will make decisions regarding these in the fourth quarter. The exact impact of these decisions may have on our accounting is not yet known. So we think it's best to let these facts solidify before providing any additional earnings guidance. I believe we are taking the correct actions to improve our business.

And with that, I'll let Troy take over and talk about those actions in greater detail.

Troy A. Clarke

Thanks, A.J., and good morning to all. Some months ago, we began to develop a plan to address Navistar's key challenges. And within the company, that has become known as our drive to deliver. And I'd like to share some of the highlights of that plan with you today.

They say that a picture is worth a thousand words. If you look at Page 10 in your deck, you will see that our drive to deliver is about clear P&L accountability across our business units. But looking on the left side of the chart, it's also about a stronger emphasis on the functional excellence necessary to improve the performance of our businesses: excellence in areas such as material procurement, quality, manufacturing and the other key drivers of our business results.

Moving to the next page. As we develop the plan, it became clear that it was important to focus on first things first and act on those things quickly and decisively. So listed here are the actions that we've already taken. As indicated, we defined an SCR-based clean engine strategy. We conducted several conversations with the EPA and CARB to ensure that we could have a clear path to certification that works with our transition timing and that recognizes the important role that the availability of NCPs and credits play for the next several quarters.

To further reduce risks during transition, we've reached out to a company that we know and have done a great deal of business with over the years, Cummins, to supply the SCR emission solution for the MaxxForce 11- and 13-liter engines and to include the Cummins ISX 15-liter as an option to supplement our on-highway product offering. This allows us to hit the pause button on further development and spending on the EGR emissions approach, and we'll step back to determine the role that this technology may play in our future portfolio.

On Page 12, let me talk about the progress on our clean engine strategy. This is something that we have referred to in the past as ICT+. With the EPA final rules now in place, we have a path to support MaxxForce 11 and 13 sales using NCPs for the majority of the U.S. We will continue to use our emission credits in California and the other 9 states that follow the CARB regulation. This provides, to our dealers and customers, assurance on the availability of product during the entire transition period.

The first MaxxForce 13-liter power trucks with SCR after-treatment will be delivered to dealers beginning in April 2013. For ProStar+ with the Cummins 15-liter, we already have orders for the first 300 units. And these initial 300 units will be delivered by the end of December, with full production beginning in January 2013.

As we continue to work our plans, what started as a turnaround effort has evolved to become the basis of our 18-month operating plan covering the balance of 2012 and fiscal year 2013.

Turning to Page 13. This plan reflects an intense focus on our North American core truck engine and parts business and the willingness to do whatever it takes to ensure our successful return to profitable leadership in these markets. As an important part of this undertaking, we are evaluating all parts of our business using a return on invested capital strategic assessment model. We're going to make decisions about the future of our business using a disciplined process, and we're going to communicate those decisions as appropriate.

We have accelerated efforts to right-size our cost structure and have implemented changes to the organization so that we can be faster, more efficient and more focused on the decision-making required to drive progress. Actions are already underway to reduce material costs; improve our quality; more effectively utilize our manufacturing capacity; reduce costs, which includes SG&A and other product development spend; and increase our market share.

On the next page, #14, this is the traditional market share chart that we've shared in prior quarters. As you can imagine, there's been a lot of noise in the system, and you can see that it has impacted our market share. And as you know, share in this business can be sensitive to the movement or lack thereof by just a few big customers. Truth is that some customers have been waiting on the sidelines to see how our interest strategy develops. The good news is that our progress in recent weeks, including our clean engine strategy and the EPA final rule, helped remove that uncertainty and positions us to begin rebuilding our medium- and heavy-duty market share leadership.

Turning to Page 15, I'd like to make a few additional comments about the return on invested capital base analysis that I referenced earlier. It's really a pretty simple concept. We're taking a look at all of our businesses outside of our core North American business and making an assessment as to both their strategic fit and their current and anticipated return on invested capital. Obviously, in the businesses where there's a great fit and the returns are there, we're going to continue to invest in those pieces of business and we're going to grow. At the other end of the spectrum, those businesses that have a marginal or low strategic fit and are not providing adequate return on invested capital or forecast to do so, we're going to fix them or they're going to become candidates to divest.

We don't intend to present a chart with specific businesses listed in each file, but I do anticipate that in the future, we could show you where portions of our revenue fall in the chart so that we can demonstrate the status and progress of this process.

Next Page, 16, overall cost reductions are on track. We began with the effort to create an appropriate cost structure based on realistic volumes and factoring in NCPs or the cost of those into 2013. We know we needed to look for ways to offset those NCPs in our cost structure along with resizing our product program spending to a more affordable level. As an example of that, we set that target to reduce costs by $150 million to $175 million per year from our Q3 spending levels. We supported that with a voluntary separation program, which is complete and approximately 500 people are in the process of leaving the organization. And we anticipate an additional reduction of force around 200 people that will be completed in the fourth quarter. These 2 actions, taken together, account for $70 million to $80 million of our planned reduction. Other actions, such as reducing direct material spend, have been identified. And we will be implementing those in the fourth quarter to deliver on this target.

Next Page, 17. So if I can just wrap up the third quarter, some significant actions have taken place to put us on a positive trajectory. EPA's final rule gives us clarity and certainty on our transition plans to the clean engine solution. Our MaxxForce 11- and 13-liter program is on track for April 2013, and the ProStar+ with ISX15 will begin deliveries in December. An affordable operating plan is being created when we can establish the focus on return on invested capital. We will manage capital expenditures thoughtfully, providing oversight and discipline on working capital as well. And we have also begun to assess the noncore pieces of our business. Our cost reductions are in process, and we have a manufacturing capacity utilization assessment underway that we look forward to sharing with you in the future. And finally, we have several organizational changes we are working through to ensure we have the right people in the right places to drive these results.

In summation, I'm very pleased with the progress that our teams have made. We're going to continue to accelerate the speed and the urgency of these actions, which will position us to deliver both short and longer-term results. And I share Lewis' enthusiasm about Navistar being a great company, and we are indeed excited about the future. And I look forward to sharing our progress with you on these and other things in upcoming calls.

So with that, I'd like to turn it over to Lewis for his closing comments.

Lewis B. Campbell

Thanks, Troy, and thanks, A.J. Well, at this point, I've only spent 12 days here, but as I said before, this is a great company with super products. Let me reiterate a few points. I believe we have an opportunity to reexamine how we look at our businesses and make the necessary changes that Troy and A.J. have talked about. And let me point out that we recently reorganized to hold ourselves even more accountable to this great company and to you, our investors.

North American Truck Engine and parts is the heart of our business, and it will get the lion's share of focus for the foreseeable future. By the way, we intend to align our incentive metrics to have a significant portion attributable to ROIC for all of our bonus-eligible employees. I want to complement Troy and A.J. on their plans that they have already put in place. And as I see it, my role is to add a sense of urgency to everything we do. I believe this will ensure that we are layer -- laser-focused on removing those big boulders in the stream, as well as becoming more transparent to our investors. And all of these actions should help restore our profitability and increase our shareholder value for years and years to come. And I do look forward to meeting many of you in the near future.

With that, I'll turn the podium back over to Heather.

Heather Kos

That concludes our prepared remarks. [Operator Instructions] Operator, we're ready to open the lines.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Henry Kirn with UBS.

Henry Kirn - UBS Investment Bank, Research Division

Could you give a little more detail on the expected cash burn over the next quarter?

Andrew J. Cederoth

Sorry, Henry, you broke up there. On the next quarter?

Henry Kirn - UBS Investment Bank, Research Division

Sorry. Could you give a little more detail on the expected cash burn for the next quarter?

Andrew J. Cederoth

Sure. I think when you step back and you look at it, you should expect that cash earnings will be negative, which includes the estimates for our severance costs and our restructuring actions that we've taken, we've put underway. Working capital will be negative for the quarter, as we talked about the impacts of volume within North America and the impact of the military receivables. Now obviously, if we can collect that military receivable, that creates an opportunity to improve that. We expect that we'll spend about $100 million in capital as we complete the projects that are underway. And then we'll have some incremental pension and OPEB funding requirements within the fourth quarter. But those are the big elements of cash flow in the fourth quarter.

Henry Kirn - UBS Investment Bank, Research Division

That's really helpful. And then as a follow-up, can you talk a little bit about the hurdles for a business to stay in the portfolio? Any more specifics around the ROIC that you'd like to see in a business before you'd make [indiscernible]

Lewis B. Campbell

So this is not a new process to many of us. So we've kind of seen this movie before, and we know it can be accomplished. Don't think of this as us selling off everything but North American truck engine and parts. That's not the drill. We have a lot of good initiatives underway, and so we'll be working hard to understand why they aren't positively contributing to ROIC. And I believe we'll make a lot of progress in those individual initiatives. If there is an initiative, however, that we can't see our way clear to within reason, get a positive ROIC versus our weighted average cost of capital, then we'll have to take another step. And hopefully, there won't be too many of those. But whatever it is, it is. And we're going to stay focused on this until we get that job done. Would you add anything to that, Troy?

Troy A. Clarke

No. I think that captures it very well. I think we're refraining at this point in time, from throwing out our hurdle rate. It's really a process that I think a lot of the value is the analysis will tell us the kind of things that we need to be doing.

Operator

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

Jerry Revich - Goldman Sachs Group Inc., Research Division

[Audio Gap]

on how you're thinking about the U.S. engine business within your ROIC framework? It looks like the business lost, call it, $300 million per year over the past couple of years. Are there any product lines that you'd consider in that exit bucket? Is that up for discussion at all? If you could just help us get a sense for how you're thinking about the opportunities, or are you committed to maintaining the full range of product lines that you currently have?

Troy A. Clarke

Well, Jerry, let me say this. Integrated engines is core to our strategy and will continue to be so. And so we've been careful to say that our core North American business is about truck engines and parts. And that's what we still need going forward. However, within that portfolio of businesses, because our Engine business is more than just a single engine and it's more than just the engine that goes into our truck, there are pieces of that business that will run through this assessment, our strategic assessment, to make sure that the decisions that we made in the past are still the right decisions going forward with regards to the level of integration in the value chain, as an example, and what we purchase versus what we make. So those things are all on the table, all in an effort for us to make the right decisions, to bring our business back to profitability and leadership as quickly as we can.

Jerry Revich - Goldman Sachs Group Inc., Research Division

And I'm wondering if you could flesh out your organizational structure in a little bit more detail for us in terms of the changes versus the last time you announced the structure, specifically you mentioned about a P&L focus. Just help us understand at which levels you're going to be allocating P&L responsibility.

Troy A. Clarke

Well, I think if I could just make a comment on that, there will be a series of organizational announcements out. I really don't want to foreshadow those on the call, if I can. But we'll make these announcements. Many of them will be public. Some of those are in fact reorganizing inside the company to put the right decisions with the right folks. But if you can envision, just to kind of give you a tip-off, our business is about designing great products, making great quality products, selling those products. And so with the left side of the chart #10 that I referenced, a high degree of fidelity and emphasis on driving those 3 functions in particular, again for the satisfaction of our customers and, ultimately, the satisfaction of our shareholders.

Jerry Revich - Goldman Sachs Group Inc., Research Division

So functional focus, just to make sure I am translating that right.

Troy A. Clarke

Yes, additional emphasis on functional focus.

Lewis B. Campbell

Yes, let me add to that because I referred to this senior leadership team, which is about a dozen folks. We're not changing the reporting relationship out from under Troy. So Troy will still have both of the big selling functions. He'll also have -- we've also decided to move purchasing under Troy to get more focus on material costs. He'll have engineering. We'll see a much more clear line of sight between me, Troy and the rest of the organization. And we're doing this as quick as we can because we believe we can make better progress if we're all in the same room at the same time. Our first meeting is Monday -- sorry, Wednesday at 1:00. And we're going to meet weekly until we get ourselves totally focused on taking this company where we want to be. We've got a good operating plan, too. I was really pleased to find that in place or almost in place when I got here. It's being developed, and it will be finalized for our board meeting in October.

Operator

We'll take our next question from Stephen Volkmann with Jefferies.

Stephen E. Volkmann - Jefferies & Company, Inc., Research Division

I'm curious whether you, in part of your due diligence or even since joining the company, have had any discussions with some of your larger shareholders and whether they're kind of on board with these plans or have had any input or feedback for you.

Lewis B. Campbell

Well, I have not had any conversation with them. And in fairness, if I had, it wouldn't be fair to comment. I will say this, though. Look, there isn't anything I can think of anybody outside would want to do that we're not doing. So if you want to take a look at looking at every single initiative we have in place to make sure it drives profit, return on invested capital ahead of our weighted average cost of capital, we're doing that. We've got a very strong team in place. We reorganized to make sure that the top 12 people in the company are marching in lockstep. We've got really good handle on cash. I don't know. Maybe you guys can tell us the things you'd like to see us do differently, but I don't know what else we could be doing. And as I tried to say on the call when I was talking, this company is a good company and the leaders already had put in place a pretty doggone strong operating plan. It still needs a little more work and we may find a few more things we want to do, but this is a good team and I think we're organized to win. I really do.

Stephen E. Volkmann - Jefferies & Company, Inc., Research Division

Okay, fair enough. I'm wondering, can I assume that the fourth quarter, A.J., is going to be the biggest cash burn quarter. And that things kind of get better from there?

Andrew J. Cederoth

I would expect so, Steve. But let's let that play out. But we've done a lot of stress testing around our forecast going forward. As you can imagine, as we prepared for this term loan facility that we did last month, that we did a lot of scenario planning and really looking at how long would it take to effect the change in the engine plan and where market share could go and what to do that. So obviously, I've been looking at a lot of various stress-tested scenarios on that. I think our cash is adequate to bridge us through this transition plan. And as we get this executed, I expect market share will grow, volumes will come back and cash flow will again be positive.

Stephen E. Volkmann - Jefferies & Company, Inc., Research Division

And then maybe one just quick one for Troy. As you think about the change in engine strategy, has that changed the way you think about the ultimate EBIT margin opportunity in the company? In other words, when we're getting all the way through all these changes and we have some sort of a normal year in the market, I guess you used to think of kind of an 8% to 9% EBIT margin opportunity for the overall company. Has that changed, given that you're going to have to pay, I guess, probably some more to suppliers and so forth? How do we think about that?

Troy A. Clarke

Well, I would say we haven't given up on that. That, I think, is still, directionally, the goal that's in the right zip code. As we work through, I think, the next 3 quarters, in particular, we'll have a lot more -- a lot better line of sight on our cost structure and the things that we're doing to modify that. And then we'll have our new products in the market. We still believe strongly that our products are very competitive offerings that should be able to demand a price in the market commensurate with the quality and service that they offer to customers. So I would say we're not backing off on any direction or changing any direction in that regard at this time.

Lewis B. Campbell

Lewis again. So we -- I've made quite a bit of my comments today around return on invested capital and I don't take any of those back. But we're not taking our eye off margins. We're not taking our eye off EBITDA margins. We know exactly where we want to end up because that's a strong measure of performance as well. And we have a lot of emphasis on reducing our material cost, which is the next big area, I think, of improvement. And once we get the SCR components on our engines, then there's other improvements we already know we can make going forward. So stay tuned, more are coming.

Operator

And we'll take our next question from Andy Casey with Wells Fargo Securities.

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

I guess I wanted to start out, you have the goal to improve ROIC and refocus on the core truck engine and parts business and NAFTA. Can you discuss the return to profitability? I mean, both in the near term you're addressing current unprofitable NAFTA performance in what has been an above-normal volume market. And then looking forward, you're likely facing higher supplier-related costs related to the Cummins and the increased content next year. On that supplier costs, can you kind of give us some buckets? How much do you think is going to be covered by increased pricing and how much of that really needs to be offset by core cost reduction?

Lewis B. Campbell

Let's try and tackle those a little bit at a time, okay, Andy. I think as we go forward, the things that we've done right now is really looking at the size of the overall corporate structure and taking action to reduce that going forward. So I think as that plays out into 2013, that will have a positive impact on the business. Clearly, we're going through a transition plan here of modifying our engine strategy and integrating the SCR components into the trucks. And that does come with additional material costs. I think that will have a better -- I think that will also -- let me just be clear here -- that eliminates the NCP penalty that we're currently paying on those engines. So going forward, that falls off. Then I think on a more long-term basis, I think you step back and you look at things like a better manufacturing strategy that will drive costs out of the system. You look at the opportunity to eliminate some of the quality concerns that we've had going through this year. And then even beyond that, I think there's cost optimization around integrating the Engine and the truck and the SCR system in a more effective manner that will take true material costs out of the system. So I think those are the key elements that drive us back to profitability.

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

Okay, if I could follow up on the internal core cost reduction. In the release, you talked about $150 million to $175 million from the run rate of the first 3 quarters. In the first 3 quarters though, you had previously discussed things like engineering integration and so forth. Could you give us kind of a net, what you expect 2013 cost reduction relative to 2012 would be?

Andrew J. Cederoth

That is our -- our stated goal of $150 million to $175 million, Andy, is just pure cost reduction year-over-year. Go from our third quarter annualized run rate. Next year, our objective is to reduce that run rate by $150 million to $175 million.

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

Okay. And then lastly, the longer-term question, how do you suggest we should view the underfunded postretirement obligations as it relates to ROIC and cash allocation, especially as I look out to 2014? You have a fairly large convertible debt obligation coming due.

Andrew J. Cederoth

Well, I think all of those items need to be taken into consideration. When you look at the unfunded pension and the OPEB, those require about $180 million drag on earnings. So as we can improve those and reduce that drag, that's an opportunity to improve overall results. I'm going to withhold commenting on what we're going to do around the 2014 refinancing until we let things play out a little bit further.

Operator

We'll take our next question from Robert Wertheimer with Vertical Research Partners.

Robert Wertheimer - Vertical Research Partners Inc.

So Lewis, I wanted to ask about your comfort level as you did your due diligence, and then I guess stating what's your insight on the 13-liter in April. Obviously, it seems to be very doable but it's an accelerated time line, it may come with trade-offs on how much work you can do on calibrations, et cetera. So just how did you get comfortable with that? Are you already working with Cummins on it, or is that to start when the final agreement is signed? And what's the risk around it?

Lewis B. Campbell

Well, let me go backwards. We [indiscernible] are already working with Cummins. You can bet your [indiscernible] on that. And we have a pretty clear line of sight, as best I can tell before I came to the company and then after I've been here. That's been -- one of the most important things we can do is to get this SCR technology into our product line as quick as we can. We know which engines to introduce it first on. We know what we have to do. We've got a plan in place that allows us to accelerate the necessary certifications that we need. We've got some more work to do there. But we wouldn't have reconfirmed that timing on today's call if we had a doubt that we weren't going to make that timing. And we're going to spend one heck of a lot of time on it weekly to make sure that all of our dates are hit. We like the ISX 15-liter a lot. And so it coming in right now is a big plus. And so -- I mean, as best as I can tell you, we've had a lot of long sessions on it, we're going to hit our dates.

Robert Wertheimer - Vertical Research Partners Inc.

Excellent. And just one other quick question on what else you found as you were coming to the company. Any core concerns? The warranty issue obviously had popped up and it looks like it's settled in a bit, although you still did have a prior-period adjustment as opposed to maybe a reversal of experiences and it's not expanded to a wider pool of engines. So I'm just curious what else -- if you look at the internal warranty data and are comfortable on it, if anything else may pop up for concern?

Lewis B. Campbell

We have had a couple of meetings on that. I've only had about 12 days here. But I understand warranty well. I've got some experience on that from my prior life. So I think it's good news that our warranty expense is much less this quarter than it was in the prior 2 quarters. So we have gotten some things behind us that we needed to get behind us, primarily related to the EGR valve system. I'll just call it that for now. Those problems also tend to get better as we move SCR onto our engines. So that's a plus. We will have a very detailed approach to eliminating warranty defects and starting to get some metrics in place like defects per thousand and defects per million [ph]. And that in turn usually results in much more improvement in our overall warranty costs over and above what we accrue each time we sell a truck. The other thing I forgot to mention. Some, Steve and others may remember, I'm a certified Lean Green Belt. So lean is pretty important, the way I think about running the business. That's one thing I missed. I saw a little bit about it during the due diligence. But I was really pleased to see how much progress that Arch and Troy and others have made in leaning out our facilities because that also brings a lot of profit to the bottom line as well. I hope that answered your question.

Operator

We'll take our next question from Brian Sponheimer with Gabelli & Company.

Brian Sponheimer - Gabelli & Company, Inc.

Just a question, first, on how you as a company expect to sell your fleet customers and your dealers on SCR after 4 years of a fairly highly combative ad program against SCR? And do you anticipate having to do anything unusual regarding guaranteeing residuals in order to provide some greater comfort to your customers?

Troy A. Clarke

Hey, Jack. Jack Allen is here with us. I'll throw that ball to you.

John J. Allen

Sure, Brian, I'll take that question. We have had significant conversations with all of our major customers about our strategy of moving from our current technology to SCR. And the bottom line is this really goes back to some of the earlier comments that were made about our ProStar product. We're confident today that either with an EGR engine or with an SCR engine, ProStar is the most fuel-efficient truck on the road today. The drivers like it. And so the customers that we have today, we will transition them into our SCR product. Now we believe that we can demonstrate, because of all the work we've done on EGR in the past and because of the inherent fuel economy of the vehicle, that we can just demonstrate a competitive advantage. And we're just moving forward with these customers. We're not looking back over the last 4 years and rehashing the situation that we're in. The reception's been very positive. We're talking to more customers today than we ever talked to before about our newly constituted product line. Customers continue to be interested in the 13-liter. And now we have a broader base, and they're also interested in the Cummins ISX 15-liter. So we're very bullish on what our opportunity to return to what we view as our right level of market share here throughout 2013.

Brian Sponheimer - Gabelli & Company, Inc.

And just shifting gears to defense, you just -- you revoked your protest on JLTV after you weren't part of the down select. How are you thinking about the military business as you're going forward? Is that a business that's potentially not part of this core North American business? Just some comments on that would be helpful.

Lewis B. Campbell

Before Arch -- Arch is here, too. Before he speaks up, look, everything [indiscernible]. So there's lag. And start right there and say we like the military business. I'm personally very comfortable with it, coming from where I came from. But it's going to have to withstand the same scrutiny that the rest of our businesses are. But I think it will, but we'll have to wait and see. Arch, maybe some comments about the protest withdrawal, et cetera.

Archie Massicotte

Yes, we did evaluate where we stood within that protest and both from the cost side and what we would gain from where we saw it going forward and how we would benefit from that protest, we opted to pull out. I mean, the government made their selection, they went down the path. They marked the 3 that were successful. But there's another bite at the apple. It's not the end of the day for JLTV. And we're reading things right now where with sequestration and everything else that's in play right now, JLTV could slide out to 2020 before they see a production contract. And that's public today, coming out of some Congress congressional papers. So we're not giving up on any of the business. We have a solid business going forward into next year. We do have line of sight on backlog that we're fulfilling for 2013. And we feel very comfortable where we're at right now from a military business. And we're still a key player.

Lewis B. Campbell

One more thing I'd add, these guys do have a good focus on this business. They beat my former company on the MRAP. So we were thinking they were pretty hot. It's not unusual to lose a contract. I mean, I've seen that movie before. We had to file a protest by Friday or not do anything at all, and we wanted to get a look to see where we could do better in the future. We had some ideas on that. And so we're just going to go on down the road as Arch talked about.

Operator

We'll go next to David Leiker with Baird.

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

I guess, first, you put a little bit of insight into your slide deck as you'll -- with the chargeout that you're looking for Q4, down significantly from the old number. It's down a bit sequentially from Q3. If we take away the unusual items, severance charges and things like that, that would imply that from an operating performance, Q4 looks similar to maybe a little bit worse than what we saw here in Q3 directionally. Does that make sense?

Troy A. Clarke

When you say operating performance, what do you mean? You mean manufacturing segment profit?

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

Yes, that's probably the best number to look at.

Andrew J. Cederoth

Yes, I think it's going to improve a little bit in Q4. But you're on the right track, David.

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

Okay. And then secondly, as we look at the capital structure, and if you get some sense longer term of what your view is as a comfortable capital structure in terms of debt relative to equity or EBITDA. And within that context, the healthcare portion of that unfunded liability is a pretty significant cash outflow for the company. And if there's any thoughts there of the ability to do a viva [ph] trust or prefund that and move that off to a trust-type structure as opposed to keeping it internal?

Lewis B. Campbell

Well, I can't say too much about that. I'm going to let A.J. talk a little more about capital structure in a second. But on that unfunded pension liability, that was well available to look at before I came here. And in conversations with the board and others, I think we have a plan to possibly address that in a different way, but I don't want to say too much about it. And I think we'll work through that as we'll work through any of our other issues. But that is an issue. I mean, it's on our plate. It's not something we're kind of looking the other way and pretending it's not there. We've got a list of 10 or 12 big things we're working on. It's one of those. But I think we'll work through that one. I hope to -- plan to.

Andrew J. Cederoth

And David, as it relates to the balance sheet, I think you just have to take a look at the pension, the OPEB and the overall debt level of the company. And it doesn't take a long analysis to figure out that those need to be our priorities and that we do need to work diligently to improve the results of the company and to improve our cash flow and to reduce our overall debt level, however you choose to measure that.

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

And I would suspect included in that is some willingness that, obviously, adding price in terms of using equity to reduce those liabilities?

Andrew J. Cederoth

We'll look at everything. But for right now, I think we need to focus on turning around the results of the company and moving forward with that.

Operator

And so we'll take our next question from Ann Duignan with JPMorgan.

Michael Shlisky - JP Morgan Chase & Co, Research Division

It's Mike Shlisky filling in for Ann. Most of my questions have been answered, but I just had a one quick one here. I noticed in your filing today, the cash flow for our product app and the 10 CARB states that could happen prior to the introduction of ICT+. I was kind of wondering how important those 10 states are to you as a percent of sales. Can you give us some kind of color as to how likely you are to hit any kind of gap before ICT+ is introduced?

Lewis B. Campbell

Those safe harbor statements are always tricky ones, but if you ask anybody around this table today, do we plan to miss and run out of credits? The answer is no. We think we have plenty of credits in the CARB states to have time to implement the engines as we need to in the March April time frame. It is possible, because we haven't done it yet, it is possible that something comes up and we have to slip. And we don't have an infinite number of credits. But -- and Troy can add something there, too.

Troy A. Clarke

It is about, to your question, 20% of our market. And those are good markets, and they're markets that we typically do very, very well in. And I would just endorse the comments that Lewis has already made.

Michael Shlisky - JP Morgan Chase & Co, Research Division

Okay, just quickly to follow up. I also noticed in the filing that you hadn't -- that some of your peers have filed an additional lawsuit to invalidate the NCPs from the interim rule. I guess that's what you've already paid to date. I'm not quite sure what they can sue for. It's already been sort of produced and paid. And I'm kind of wondering if you could tell us any -- what impact that might have on your cash or on your profitability were that case to be successful.

Lewis B. Campbell

Actually, you caught me unaware. As of yesterday, when I went home, I am unaware of any legal action at present contesting any part of the NCP ruling. That's a possibility that exists because 2 weeks ago, the court unfroze while the interim NCP ruling was being -- had been ruled and was being sent back to the EPA, the court unfroze the opportunity for our competitors to create additional legal actions against the EPA. But I'm unaware of that, anything else at this particular point in time. I'm not saying that there is -- that there may not be anything out there. That said, these are legal actions toward the EPA. At present we are complying with the letter of the law and intend to do so. The EPA final ruling clearly states that there is no impact on the certificates of engines that NCPs have already been paid on and are already in Cummins. I don't know if that gets to your question or not.

Michael Shlisky - JP Morgan Chase & Co, Research Division

I guess maybe I could just take it offline. It's definitely in your 10-Q today. So we can talk about it later.

Andrew J. Cederoth

It's one of those potential risk items, that there is a potential for a legal action. But as Lewis indicated earlier, I think in the spirit of the transparency that we're trying to create, it is something that we had been tracking but it is not something that is an issue as we speak.

Lewis B. Campbell

Remember what was -- what happened there. The EPA, they created rulemaking that was very much in favor by us because they didn't withdraw any certificates and reissue any certificates. And basically, in layman's terms, increased the penalty going forward. So the certificates are still going on engines. And when the final rulemaking is complete, we'll change our penalty from 1919 to 3775. And down the road we go. Since our friendly competitors would love to see us not sell trucks, they may or may not try to sue the EPA. I don't think they're going to get very far, but that's just something that we hope they don't do and will just grow out of it.

Operator

We'll go next to Tim Denoyer with Wolfe Trahan.

Timothy J. Denoyer - Wolfe Trahan & Co.

We know that one of the company's biggest strengths is supporting products. But if you hit the April target, I think you'll probably have about 60,000 or 70,000 of the post 2010 13-liter engines, with EGR only out there. Can you help us understand roughly how many sort of put options or residual value guarantees you have out on them? And if this is having any impact on cash?

Andrew J. Cederoth

I'll try and take that one. Tim, we don't have any -- every deal is different and every deal gets negotiated but every deal is accounted for on the balance sheet. So there's a variety of things that -- elements that go into selling trucks, whether that's trade-in offers or mezzanines against the fair market value lease or any other elements of that. And all of those are accounted for against the original transaction of the sale and held on the balance sheet. So I don't expect any impacts from cash on any of this. The values of our trucks are holding up very well. And so I don't think there's much there to be concerned about at this time.

Timothy J. Denoyer - Wolfe Trahan & Co.

Okay. Can you give us a sense of how much you have on the balance sheet in terms of used truck inventory?

Andrew J. Cederoth

Used truck inventory is ranging around $150 million at this time.

Operator

And we'll go next to Andy Kaplowitz with Barclays.

Vlad Bystricky - Barclays Capital, Research Division

This is Vlad Bystricky on for Andy. Just on the introduction of the Cummins ISX 15 engines, can you talk about whether that will ultimately be available on all of your heavy-duty trucks? And sort of what percentage of your heavy-duty truck sales do you think will have the Cummins engine as opposed to your own 11- and 13-liter offering?

John J. Allen

Vlad, this is Jack Allen. Initially, we'll introduce the ISX 15 in where we think will be the highest volume product, which will be the ProStar. But we'll ultimately add it to a couple of vocational models. How do we think it's going to sell throughout the whole portfolio? As you look back in time, the 13-liter market is rapidly gaining progress against the 15-liter market. And actually today, there are more 13-liters sold in Class 8 trucks than there are 15-liters. So we expect that trend to continue. But we believe that going forward, our market share of the 13-liter market will be about equal to our market share of the 15-liter market. So we think we can equally participate in either one. And ultimately, we'll be indifferent to whether -- to how that market plays out by having a broad product line that provides the engines in each [indiscernible].

Vlad Bystricky - Barclays Capital, Research Division

And then what's your level of confidence around the April time frame for having the SCR after-treatment available? And what gives you that level of confidence that you have?

Troy A. Clarke

Well, as we have -- as Lewis indicated earlier, this is something that we track on a daily basis. We have a very detailed time line, I would say, as detailed as anything I've seen in my experience. And I might ask Lewis to comment on that as well. We have had on-site, for several weeks, co-located Cummins engineers who have actually done the task that we are doing, actually put this particular SCR system on the back of somebody else's engine and walked it through the certification process. So from the hundreds of line items that [indiscernible] level of detail, I would tell you that it is a progressed [ph] program. It is aggressive. But it is not based on a whole bunch of Hail Mary passes. It's based on a lot of good blocking and tackling and just lining things up that need to get done tomorrow and get them done. So I have a high degree of confidence. And from what we see today, we'll be able to stay on our program. Lewis, you've seen some of the detail and you've walked through it. I would ask you if you want to...

Lewis B. Campbell

Obviously, one of the first things I did, and I'm an engineer by background so I kind of like this kind of stuff. Anyway, and I've spent time with the engineering team. And because I knew that I was going to be on this call this morning and I wanted to assure myself, just the way I look at things, not the way necessarily anybody else looks at them, I've been involved with a lot of product launches in my day. And here's some stuff I found. First, everybody's focused on getting the job done. I like the fact that nobody is trying to resurrect the technology that almost got us there but didn't. We totally turned the page on that. So everybody's refocused and rededicating to SCR. And as Troy said, the fact -- I thought -- I didn't know that we were -- had Cummins co-located and having them here -- they've been there, done that already. So we're not having a fresh bunch of eyes look at it and say, "Geez, I wonder how we can get that done." So for as much as we can see since I've been here, I'd have to say, Troy, I'm pretty comfortable with the fact we're going to get this job done when we promised, if not earlier.

Operator

And I'd like to turn the conference back over to our speakers for today.

Heather Kos

Thank you. I'd like to thank everybody for participating today and for any additional follow-up, please contact myself or Randy Diaz and have a great day.

Lewis B. Campbell

Thanks, everybody. Have a good one.

Operator

That does conclude today's call. Thank you for your participation.

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