Navistar International (NYSE:NAV) Q2 2014 Results Earnings Conference Call June 5, 2014 9:00 AM ET
Heather Kos - Vice President, Investor Relations
Troy Clarke - President and CEO
Walter Borst - CFO
John Allen - COO
David Leiker - Robert W. Baird
Stephen Volkmann - Jefferies
Andrew Kaplowitz - Barclays
Jerry Revich - Goldman Sachs
Ann Duignan - JP Morgan
Steven Fisher - UBS
Andy Casey - Wells Fargo
Joel Tiss - BMO Capital Markets
Jeff Kauffman - Buckingham Research
Adam Uhlman - Cleveland Research
Good day, ladies and gentlemen, and welcome to the Navistar second quarter 2014 earnings results conference call. [Operator Instructions] I would now like to introduce your host for today’s conference, Heather Kos, Vice President of Investor Relations. You may begin.
Good morning, everyone, and thank you for joining us for Navistar's second quarter 2014 conference call. With me today are Troy Clarke, our President and Chief Executive Officer; Jack Allen, our Executive Vice President and Chief Operating Officer; and Walter Borst, our Executive Vice President and 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 Forms 10-K and 10-Q and our other SEC filings.
We would also refer you to the Safe Harbor statement and other cautionary disclaimers presented in today's material for more information on the subject. With that, I'll turn the call over to Troy Clarke for his opening remarks.
Thanks, Heather. Good morning, everyone, and thanks for joining us. This morning, Walter, Jack, and I will review our Q2 financial results and other progress on our [unintelligible]. We advised you on our first quarter earnings call that going forward we would demonstrate meaningful quarter over quarter improvement, and we clearly did that in our second quarter.
Let me highlight what we’ll talk about today. First, EBITDA. We reported $82 million of adjusted EBITDA for Q2, which was better than our projected guidance range. The most significant adjustment was an intangible asset impairment related to Brazil. We also had a substantially reduced preexisting warranty adjustment when compared to previous quarters and some miscellaneous restructuring charges. Walter will touch upon all of these items in more detail.
Second, we continued to meet our expectations on cash in Q2. We once again hit our cash guidance. This is our seventh consecutive quarter of cash management to meet or exceed our goals.
Next, industry and share. The North American traditional industry has grown beyond our initial forecast for the year. We would now call the class 6 through 8 truck and bus market for 2014 between 317,000 and 335,000 units.
Our orders and retail market share grew both sequentially and year over year. Our production and backlog continued to strengthen and preliminary May orders look strong. We will finish this year with year over year market share gain and significant volume increases. However, the strong performance of the industry in Q1, coupled with market growth, will make it difficult to average 21% market share for the year.
We are pleased with the response to our new products in the market. Our customers recognize and appreciate improved quality and performance of our new products. Our ProStar is being noticed for all the right reasons. One of our major fleet customers just recently shared data from their pre-delivery inspections with ProStars receiving the highest scores among all the competitors for which they received units.
Another customer recently shared data that the percentage of ProStar vehicles with zero defects in the first 90 days in service is at least 50% higher than any other competitor. This is a testament to our commitment to quality, and we believe it will bring customers back to our brand.
In our class 6 and 7 and bus products, the recently launched ISB powered medium duty trucks are gaining momentum in the marketplace, and the launch of our 9/10 liter engine with SCR is on track and progressing well.
We’ll start deliveries of DuraStar and WorkStar trucks powered with the 9/10 liter with SCR in mid-July, with about 60% of the high-volume applications covered at the initial launch. We will continue to launch the remaining product configurations in July and August. This sets us up for orders in the second half of the year that will translate into key share growth next year.
Next, we will report reduced spending in the quarter. Our Lean initiatives, engine restructuring, and previous reduction in force actions have helped us further lower our structural costs. In the quarter, we achieved $92 million of structural cost savings. Year to date, we are at $159 million. Given this performance, we are raising our year over year target to $250 million, and we continue to take aggressive actions to optimize our cost structure.
The last major item impacting our results in the quarter is Brazil. The economic situation there continues to challenge the entire industry. Year over year, our MWM business is projecting a 17% decline in demand for our engines. We are responding by implementing cost reductions and restructuring actions to further lower our breakeven point.
2014 started with a difficult quarter, due to a lull in sales because of the transition to the Cummins ISB in our class 6/7 product and a large warranty true-up associated with extended service contracts.
These issues are now behind us, and we are seeing good progress every day. There will continue to be bumps in the road, but we’ve become a more capable team in responding to the challenges that crop up. We are progressing and we are building momentum. You’ll see more good things as we move forward.
On the whole, I’m pleased with the progress we’ve made towards exiting 2015 at our 8% to 10% EBITDA goal. So with that, let me turn it over to Walter and Jack, and I’ll be back to wrap up with some comments on the remainder of 2014 and 2015. Walter?
Thank you, Troy, and good morning everyone. I’d like to turn your attention to the financial results for the quarter, on slide nine. Building on our first quarter call, we continue to see benefits from our drive to deliver plan. Revenue for the quarter was $2.7 billion, up 9% compared to the second quarter of 2013.
As you may recall, last year’s second quarter results included an adjustment for lease transactions relating to prior periods, which lowered our sales and cost of sales by approximately $125 million. Excluding this item, sales were up 4%. The revenue growth is due in part to a 25% increase in traditional chargeouts, reflecting a 49% increase in class 8 heavy duty trucks and a 20% increase in class 6/7 medium duty trucks.
Adjusted EBITDA for the quarter was $82 million, after adjusting EBITDA of negative $119 million for certain one-time items in the quarter. This is the third consecutive quarter we met or exceeded our EBITDA guidance, and we’re pleased with the nearly $120 million absolute improvement in adjusted EBITDA for the first quarter of 2014.
Loss from continuing operations net of tax was negative $298 million in the quarter, compared to a loss of $353 million in the second quarter of 2013, reflecting improvements in our structural cost and lower adjustments to prior period warranty expense. Second quarter 2014 results include $151 million in asset impairment charges and a $29 million tax valuation allowance, primarily related to our Brazilian operations.
Turning to slide 10, let’s discuss our business segment results for the quarter. The North American truck segment reported a loss of $134 million, less than half the loss in the second quarter of 2013. Truck volumes were higher both sequentially versus the first quarter and year over year.
In addition, we continued to lower our structural costs, reflecting excellent progress on our cost reduction initiatives. However, the earnings improvement was principally driven by lower warranty expense, including a $122 million decrease in preexisting warranty charges versus the same quarter last year.
Warranty expense as a percent of revenue was 4.6% for the quarter. While we’re not fully out of the woods yet, warranty expense is starting to come down, driven by lower year over year warranty cash spend of 13% in the quarter.
The North America parts segment reported profits of $126 million, reflecting stronger performance in our commercial markets and lower SG&A expenses, which led to an increase of 11% in segment profit. Parts sales in the commercial markets continued to improve quarter over quarter, but the growth was unable to offset the decline in the military business. The loss of $150 million in the global operations segment was principally driven by a $149 million intangible asset impairment charge relating to the South American engine operations.
The economic downturn in Brazil continues to challenge our operations in the region, and it was determined in the quarter that the carrying value of the operations, including goodwill, exceeded fair value. The year over year comparison was also impacted by a gain of $28 million in the second quarter of 2013, resulting from the sale of the company’s interest in the Mahindra joint ventures.
The financial services segment continues to performance in line with our expectations. Profit increased to $24 million in the second quarter of 2014. Despite lower overall retail balances, financial results improved due to lower structural cost and interest income on an intercompany loan.
The financing capacity and funding maturity profile of our captive finance operations are well-positioned to support our drive to deliver plans. NFC’s debt-to-equity ratio stood at 2.7:1 at the end of the second quarter of 2014.
As I indicated earlier, adjusted EBITDA for the quarter was $82 million. As shown on slide 11, during the quarter we incurred $42 million in prior period warranty approvals principally related to extended warranty, as we continue to refine our estimates for these contracts.
We also incurred one-time charges of $159 million, which consisted of the previously mentioned $151 million in intangible asset impairments and $8 million in restructuring costs for additional cost reduction actions the company initiated recently.
Turning to slide 12, we have reconciled our actual ending manufacturing cash balance against the guidance provided on the company’s last earnings call. We ended the quarter with manufacturing cash, cash equivalents, and marketable securities of $1.06 billion, slightly above the midpoint of our guidance.
During the first half of the year, we had lower capital expenditures than previously expected, as we focus our activities to refresh our products with the SCR engine technology and cost reduction projects with a quick payback. We now expect full year 2014 capital spending to be less than $150 million. However, we expect capital expenditures to increase again as we introduce new products over time.
As you can see in the chart on slide 13, we’ve maintained a cash balance above $1 billion for the last seven quarters. This balance is higher than historical levels and well above minimum required cash levels to run the business, but gives us more flexibility to take the actions necessary to complete our turnaround.
During the quarter, we proactively addressed a large portion of the convertible notes due later in the year. As shown on slide 14, we completed the sale of $411 million of new convertible notes due in April 2019. We used the proceeds from this issuance as well as a modest amount of cash on hand to repurchase the majority of the convertible notes that come due in October of this year.
As a result, there was little net impact on liquidity in the quarter from this issuance. However, these actions did extend our debt maturity schedule, and after paying off the $166 million balance of the convertible notes in October, we won’t have any major debt coming due until 2017, when our term loan matures.
Turning to slide 15, we expect manufacturing cash at the end of the third quarter to be in the range of $950 million to $1.05 billion. As you can see in the chart at the bottom of the slide, we are projecting our ending manufacturing cash balance to be at the higher end of historical Q3 ending manufacturing cash balances.
Consolidated EBITDA for the third quarter is expected to be $75 million to $125 million. Consistent with prior quarters, this excludes preexisting warranty accruals and one-time items. Our guidance reflects the positive momentum in our core North America operations that I alluded to earlier.
Cash used for capex, cash interest, pension, and OPEB funding is expected to increase in Q3 compared to Q2, primarily due to higher cash interest payments. The increase is due to the timing of interest payments on our outstanding debt, principally the 8.25% senior notes, where we make semiannual interest payments in November and May.
Lastly, the change in net working capital is expected to be relatively flat versus Q2, even though we have fewer operating days in the third quarter and expect somewhat higher used truck inventories.
Slide 16 puts a few of our key operating metrics in historical context, and shows our progress against them in the second quarter. All of these metrics are trending in the right direction, some meaningfully.
Second quarter manufacturing revenue was up 25% from the first quarter, and 9% from the second quarter of last year. As we continue to transition our product portfolio, we believe revenue will grow further throughout fiscal 2014.
We have made the most progress in the area of structural costs. For the quarter, structural costs as a percentage of manufacturing revenue were 11.8%. This is an improvement of over 3 percentage points versus the first quarter of this year, and nearly 5 percentage points versus the second quarter of 2013. The trend in this area is favorable for us to achieve our structural cost goal of less than 10% of manufacturing revenue.
As I mentioned earlier, warranty expense as a percentage of manufacturing revenue is improving. During the first half of this year, warranty expense as a percent of manufacturing revenue was 5.3%, compared to 7.7% for all of last year.
The 2.4 percentage point improvement positions us to achieve our goal of decreasing warranty as a percent of manufacturing revenue by 4 percentage points. The adjusted EBITDA margin for the quarter was 3% versus 1% in the second quarter of 2013. Although we million more work to do, the positive trend in these metrics is very encouraging.
Slide 17 shows our goals for 2014 and beyond that we introduced in the fourth quarter of fiscal year 2013. Let me provide you some additional perspective on a few of the targets for fiscal year 2014.
As Troy previously mentioned, we now expect industry volumes of 317,000 to 335,000 units for 2014, including class 6 to 8 and bus, reflecting a shift toward the upper end of our previously stated range.
Second, traditional market share has not recovered as quickly as we had anticipated. However, we still expect a 2014 year-end run rate around the 21% market share goal. Jack will elaborate further on industry volumes and market share shortly.
And third, we continue to make significant progress toward our structural cost savings goals. In the first six months, we’ve realized $159 million of savings compared to the same period last year. In May, we initiated new cost reduction actions to be completed by the end of this fiscal year. As a result, we are raising our full year 2014 structural cost savings goal to $250 million. Importantly, this is in addition to the $330 million of structural cost savings we realized in 2013.
Summing it up, our business continues to improve as we execute our drive to deliver plan. In the second quarter, we reported positive adjusted EBITDA. Our guidance for the third quarter is similar or better EBITDA on an adjusted basis, and we expect quarter over quarter improvement in the fourth quarter as well. We continue to believe we’re on the course to achieve our long term EBITDA goal of 8% to 10% margins exiting 2015.
In closing, we expect the positive signs experienced in the second quarter, which include an improving economy and truck industry, together with our improving market share, additional cost reduction initiatives, and continued focus on cash, to position Navistar for success in the future.
I’ll stop here and let Jack provide more insight on our drive to deliver plan. Jack?
Thanks, Walter, and good morning everyone. My remarks today will center on our operational progress in Q2. On our last call, we said we would build on our progress every quarter, and we’ve done that in Q2.
On slide 20, over the past several quarters, warranty has been a topic of these calls, so let me start with some significant and positive progress on the warranty front. Our warranty spend is coming down. In fact, second quarter spending was down $23 million, or 13%, on a year over year basis.
This is being driven by lower costs for repair. There are slightly fewer EGR engines in the warranty period, but the big driver is the SCR engine, as the EGR engines that remain under warranty and the SCR engines that we’re currently building have much better quality. We believe this declining trend is sustainable going forward.
Let me talk for a moment about the industry. Our original class 8 forecast for the U.S. and Canada retail sales was 220,000 to 230,000, an increase of 7% over last fiscal year. So the industry continues to struggle with driver shortages, but customer sentiment is increasingly positive on a number of fronts: freight levels, rates, and profitability.
This has spurred an increase in new orders, and we believe retail sales in the second half of the year will be stronger than we had planned and thus we’re revising our forecast to 225,000 to 235,000 for class 8.
Moving to slide 21, that being said, the North American market is still very competitive. We hear lots of speculation that we’re being aggressive on price, but let me tell you, we compete for deals on price just as much as our competitors do, and believe me, we don’t win them all. There’s excess capacity in this industry, and a desire of our competitors to not yield on market share continues.
In spite of that, our sales momentum continued in the second quarter, with retail market share gains in every segment. Medium grew from 17% in Q1 to 26%, class 8 from 14% to 15%, combined class 6 to 8 plus bus grew from 16% to 19%. Our order share is up in all segments. Our backlog is up 82% versus year ago level, and we’ve increased production schedules at Tulsa and Escobedo, as we previously announced.
This kind of response from our customers to our product offerings is encouraging. Rebuilding our market share continues to be one of our highest priorities, and we’re working hard to win customers and reestablish our position in the market. In class 8, we now have a complete portfolio of on-highway SCR vehicles that deliver the uptime, fuel economy, and driver satisfaction our customers demand.
We’re also seeing strong interest from our customers for the Cummins ISB engine and our medium duty trucks and school buses. As slide 21 indicates, we have demonstrated market share growth with each of these launches, so there’s great anticipation for our third and final SCR group, our vocational trucks powered by our 9 and 10 liter SCR engines. They’re going to launch this month, and they’ll help us increase our market share in late 2014 and into 2015.
As far as projecting our market share for the full year, the slow Q1 start during the ISB transition and the higher industry will mean that we will likely fall short of our 21% goal for class 6 to 8, including bus. But our internal projections indicate we’ll continue the quarter to quarter growth that we’ve been experiencing, as well as a year-end run rate at or above the 21% goal.
We anticipate that share will continue to grow as we launch vocational trucks with SCR engines and we secure repeat medium, bus and class 8 business due to the quality of our recent product launches.
Moving to slide 22, I’ll now cover some additional points about the quarter. We’re really excited about our OnCommand Connection offering, which we’ve been highlighting at major trade shows this year. It’s a remote diagnostic system designed to increase vehicle up time and provide increased fleet management efficiency by supporting quicker repairs and controlling maintenance and repair costs.
OnCommand Connection currently supports more than 40,000 vehicles across 45 customers, and we can demonstrate uptime improvements for these customers and warranty savings for Navistar.
We think it’s one of the most important developments in trucking, and Heavy Duty Trucking Magazine agrees. It named OnCommand Connection one of the top 20 products of 2014. And there’s a nice article in yesterday’s Commercial Carrier Journal on our competitive advantage with this product.
These trucks performed well in this quarter. Sales were robust at $94 million, a record sales quarter. And as we had indicated on our last call, incoming receipts grew to $113 million. These trucks continue to be a big focal point for us, and as previously stated, we expected inventory to rise in Q2, as well as in Q3, due to large customer deliveries and class 8 market share growth.
We’ve opened a reconditioning center in Indianapolis, where we ensure all vehicles have the latest quality features. The EGR engines that we’ve built in the last couple of years are performing well. This process brings all vehicles up to this level of performance. We market the vehicles as Diamond Renewed, with a used truck warranty to certify our commitment to their quality.
Diamond Renewed is more than just a certified program. They’re complete, factory reconditioned trucks featuring updated EGR componentry and calibrations, and our OnCommand Connection system is standard on these used trucks.
Let me talk a moment about the parts business. In North America, we’re very encouraged by commercial revenue being up 7% in the quarter. Lower military sales, however, resulted in overall parts revenue for the segment being down 2%, but strong cost controls boosted our profitability by 11%.
In engineering, the efficiency and productivity continues, with year over year savings of $17 million in the quarter, and we continue to make progress with our medium and severe service SCR product launches that are on schedule, our quality test data continues to be positive, and coupled with the SCR emissions technology, [unintelligible] are showing improved fuel economy performance and outstanding uptime.
Our manufacturing operations continue to get better from both a cost and quality standpoint. We have initiated Lean initiatives in our plants and corporate-wide to accelerate our ability to achieve our business objectives. And this is reflected in our working capital improvements.
We continue to shed noncore assets. The latest example of that is our divestiture of E-Z Pack, which manufactures refuse truck bodies. Year to date, our SG&A savings are well ahead of plan, and expenses in the quarter decreased $75 million year over year, which reflects our intense focus on cost reduction.
As has been mentioned, in our global markets, our results continue to be impacted by the economic downturn in Brazil. Weak economic factors mean our customers are not selling as many trucks, and that has led us to lower our engine volumes. As a result, we are also implementing additional cost reduction initiatives to lower our breakeven point in our MWM operations.
So, in summary, we have been aggressively focused on improving our financial and business performance and we’re seeing positive results of these efforts. We’ll win back customers with our product offerings, our quality, which has never been better, and the great service and support of our dealer network. We’re encouraged by our progress, and we expect this trend to continue.
Let me turn it back to Troy to wrap things up.
As Walter and Jack just shared, our financial and operational performance demonstrates the momentum we are building. These trends will continue throughout the remainder of our fiscal year.
Regarding the third quarter 2014, let me summarize the points related to our guidance, which drives our belief in the continued progress to come. We believe Q3 chargeoffs will be flat versus Q2, given our normal summer shutdown and fewer operating days at our manufacturing facilities.
Volumes in our parts segment are expected to be higher. Brazil continues to be a drag, but we think most of the bad news is behind us. Manufacturing cash is expected to be in a range of $950 million to $1.05 billion. Q3 EBITDA guidance is $75 million to $125 million. We project continued progress on our structural cost and improving material performance in the second half of the year.
Our full year 2014 forecast has changed slightly. We raised our combined class 8 industry range to 225,000 to 235,000, and we project exiting Q4 with a market share run rate of 21%. We raised our year over year structural cost savings target from $175 million to $250 million, and we will continue to drive Lean initiatives across all areas of our organization to optimize our cost structure.
With our manufacturing consolidation efforts and adoption of Lean practices, we expect to lower our 2014 manufacturing cost by $50 million to $60 million year over year, further driving material cost reductions to offset the added cost of SCR. And entering 2015, we still plan to reduce another $1,400 in cost of our 13 liter SCR engine.
We remain focused on returning to profitability with our drive to deliver. Taking care of our customers, while costly, is key to reclaiming our position in the marketplace with quality vehicles and remains our top priority.
We’re great feedback from our dealers and customers that reflects our progress. They’re seeing first hand our commitment to quality, the excellent performance, great fuel economy, and outstanding uptime of our trucks. And most importantly, they believe we have the products to compete strongly in the marketplace.
The momentum is building, and every quarter we expect to build on our success. Let me reiterate one last time, our goal of an 8% to 10% EBITDA run rate exiting 2015 remains on track. Thank you for your time this morning. Let me turn it back to Heather and open the call up for your questions.
That concludes our prepared remarks, but before we go to questions, to be fair, we ask that each of you limit yourself to one question, including an optional follow up. So, operator, we’re now ready to open the lines.
[Operator instructions.] Our first question comes from the line of David Leiker of Robert W. Baird.
David Leiker - Robert W. Baird
Just wondered if you could maybe provide some color on order trends during the quarter, and then even into the May timeframe. If my math is correct, it seems like your 6 through 8 share is being booked at the high teens right now. And just wondering if that provides you with the right trajectory to exit the year at the 21% mark.
Our order intake supports the statement we made about how we do expect quarter to quarter improvement in our retail market share, and we expect to exit the year at or above the 21% mark. So we’re comfortable with where our receipts are coming and trending. It’s a tough, competitive market, but as we’ve introduced new products, and the customers have experience with them, that’s when we see an uptick in our order rates.
David Leiker - Robert W. Baird
So even as the market’s strengthened in May, we got a good order number the other day, I would imagine your order share is actually going to start moving higher to support the higher retail share.
Our orders in May were consistent with where they had been the last number of months.
David Leiker - Robert W. Baird
And then just one follow up. In thinking about the 8% to 10% profit target, it looks like the share trajectory coming out of this year might be a bit lower, but you’re offsetting that with good cost and warranty performance. What sort of sensitivity is there around volume and hitting the 8% to 10%? What is the lowest chargeout level or utilization you might need to support the 8% to 10% mark?
What we have said previously was an industry that’s running about where the industry is running today, what was in our calculation was a market share number somewhere between 22% and 24%. So we thought at the time that we were being fairly conservative. So far, our internal projections of where we’re going to be in market share doesn’t threaten those results. Let me just state it that way.
On the other hand, we are also counting on favorable warranty performance over time, and we’re seeing that now. We’re counting on continued cost reduction initiatives from the implementation of Lean. We’re seeing that now as well. So inside the company, anyway, as much as you may perceive there’s external pressure on the pieces that get us to those results, internal to the company we’re seeing favorable variances as well. So we believe firmly that we’re still on track.
Our next question comes from the line of Stephen Volkmann of Jefferies.
Stephen Volkmann - Jefferies
I have a detailed question on slide 16 and 17, and so maybe this is for Walter. I don’t know. But I guess I’m looking at the charts you provided on slide 16, which show your warranty expense down by 500 basis points maybe, something like that, since the fourth quarter. And it looks like the structural costs are down by a few points already, which is great to see.
And I guess I’m just trying to figure out how should I square that up with the fact that the margins, they’ve improved, but they certainly haven’t improved as much as it might be implied by the various things that have happened here in your favor. And I guess there’s probably timing issues with warranty and all that kind of stuff, and maybe that’s not the full picture.
But I’m just curious, Walter, how you think we should think about this, because it looks like you’ve gotten a lot of the benefits already and yet there’s still obviously a lot of work to do to get to that 8% to 10%.
We have made good progress, first of all. I guess it kind of depends on whether you want to look at adjusted or unadjusted EBITDA results. So on the warranty side, in particular, we did have a significant improvement of $122 million year over year related to preexisting warranties. So if you’re looking at the amounts on chart 16, that’s embedded in there, and that’s hopefully not going to be repeating itself.
So I think one probably needs to look at more on an adjusted EBITDA basis, which is why we report our numbers that way as well. On that basis, we probably have a couple of percentage point improvement year on year, quarter to quarter, second quarter to second quarter. So some of the warranty is flowing into that, because of the progress we’ve made there, so on the structural cost.
We do have some headwinds, though, on the materials side related to the extra SCR costs that we’ve added to our engines this year, which we’ve been public about previously. So that’s offsetting that to some degree.
As I look at the numbers, maybe similar to you, I’m looking for all this goodness to start flowing down through. I think Walter’s point is, one, we are seeing that flowing through, especially when you take out the one-time adjustments for the quarter. But you’re not seeing as much of it flow through - neither am I - as we want right yet. And part of that has to do with the fact that we’re selling year over year a higher percentage, obviously, of these SCR engines, which have higher material costs for us.
And thus the importance of us continuing to drive our material cos activities, pulling off some of the EGR cost still, which I referenced in my comments. But just a dollar’s a dollar. We need to save cost any place we can on the material cost of the truck. That’s still a pretty big influence for us, or an influence of a couple of percentage points anyway.
And the second thing is sales mix in the quarter. Sales comes at us kind of lumpy. Sales mix in this particular quarter, there were, as you probably would note with the used truck inventory, went up, which kind of implies that we are driving in the quarter a lot of sales to very, very large customers, which have different margin structure than when we sell through dealers into small customers.
So there’s two pieces of that, and I would say that as I look at the numbers, those are the two most significant pieces that will be corrected as we go forward. So we’ll see the full Ben of the savings that we’ve created, both in warranty and our SG&A savings.
Stephen Volkmann - Jefferies
And then I guess just maybe a quick follow up on the warranty. Jack, I think you mentioned that a lot of the indicators that you’re looking at in terms of the more recent engines are operating better. And I guess I’m curious, warranty accounting is always somewhat arcane, but I sort of thought that the step up accruals that you would need to do would be if things were getting worse, and that you might not need to do those if things were actually getting better. And maybe I’m just not fully versed in warranty accounting, but I guess I would expect maybe not to have any of those step up charges if the population’s actually performing better. Maybe just set me straight on that?
Maybe I’ll try to answer that. Jack gives me the same question all the time, actually, and Troy too. [laughter] Hopefully we’ll see the warranty accruals reflect more of this over time, but we follow warranty cash expenditures as an early indicator of what’s happening in warranty. You will have noticed, and it’s shown on that chart that we just talked about, on 16 in the presentation, you know, warranty expense as a percent of revenues is coming down.
So we still had some preexisting charges in the quarter. Those were related to extended warranty, where we had some bigger charges a couple of quarters ago. So we do still need to look at that every time. But if these results continue to come through on the cash spend side for warranty, then we would ultimately expect that to also hit our accruals favorably.
Kind of how the warranty accrual process works, as you probably know, is you’re relying on a forecast model that basically projects a range. The range indicates some statistical significance with a lower and an upper bounds, and one point or two points even below that range isn’t enough to trigger us revising an accrual, let’s say.
So there’s kind of these rules in that process that say, on any particular vintage of product, when 25% of that product becomes mature through its warranty cycle, then that becomes statistically significant, and then you can then go through the math to make the proper adjustments.
So all these roses that are now blooming on the subject of warranty, you know, don’t quite make the garden, but if we keep them month after month after month, they will, in fact, as Walter has indicated, begin to tug that down. And as you’ve noted, the first thing we see, Walter said leading indicator, lower cash spend per month, we need to keep that up. Next thing you’ll see is lower prior period warranty adjustments and then again we’ll see all that flow to the bottom line.
Stephen Volkmann - Jefferies
So on page 16, Walter, the chart you provided, is that cash warranty expense?
It’s expense. It’s not cash, and it includes preexisting.
Our next question comes from the line of Andrew Kaplowitz of Barclays.
Andrew Kaplowitz - Barclays
Troy, can we talk a little bit more about the Brazilian business and global operations in general? We all have seen the data in Brazil getting worse, and you talked about that in your forecast going forward. But can you offset some of that with your JV in Mexico and cost cutting? Or should we expect a loss here going forward? You were about breakeven ex impairments. So maybe a little more color about sort of what you expect here over the next 6 to 12 months, in global operations.
I’d like you to think about our global operations as really three pieces. One is Brazil, one is an export business that primarily serves the Andean countries, the Spanish-speaking countries of Latin America. And then the third one is the JV we have in China, actually, with a company called JAC. Our Mexico operations are actually included in our North America results. They are not JV. It’s a wholly owned subsidiary of ours.
In that business portfolio of three pieces, I’ll work backwards from JAC, it is a joint venture that is very nascent. And although it’s not losing any money, it’s not making any money either at this point in time. It’s actually in within its first 12 months of operation, and we’re very pleased with the prospects that we see over there, especially in the case of China, where there seems to be a clamor for engine technology to meet the more stringent emission requirements.
So we’re really pleased with how that venture is proceeding. Typically, a venture like this would be kind of a sinkhole that you’re filling in with money, and in fact we and our partners have been able to manage it so that is not the case.
We have this truck export business, which is a fairly constant business for us. The markets in that area of the world kind of consume trucks at a certain rate. We happen to have a very privileged market position, over 20% market share position. And it tends to be a profitable business for us, by and large because they take the same type of trucks that we build that are in North America.
But the largest piece, the largest portion of that pie chart, is in fact our Brazil operations, largely the MWM engine operations, which basically serves the whole market down there. So it’s kind of hard. It’s hard for the balance of our global operations to offset the kind of reductions that that industry in Brazil has seen.
So is it feasible for us to reduce costs? Yes. Can we restructure? Yes. We’re doing that. Brazil, like a lot of foreign countries, have labor and other laws that restructuring isn’t something you do in 30 days, it’s something you do over the course of six months. Those actions have all started for us, so we will make some significant reductions in our operating costs.
But in the meantime, it’s not feasible for us to offset those losses with gains in the other two major pieces of our global. Someday, it will be, by the way. As our joint venture in China matures and grows, and we reestablish a bigger presence over there, that’s the goal, but today that is not the case. Brazil is still the biggest piece of the puzzle there, and it takes some time, actually six months, from when you start to when you can really execute significant cost savings that kind of require basic [unintelligible] down there.
Andrew Kaplowitz - Barclays
And you’ve had nice improvement in your class 6/7 share, but not as much movement in class 8. How much more difficult is it to repenetrate the class 8 market? And is there anything you can do more to help you get share? And then have you seen any improvement in pricing in that class 8 market for you guys?
If you look at the chart on page 21, the biggest thing that’s going to happen here to our class 8 share going forward will be the introduction into the vocational markets of the SCR product. So we’ve been able to demonstrate in all other segments share growth, as we’ve introduced the SCR product.
So one of the things that’s happened here so far this year is we’ve seen our share in the [severe] service or vocational market, we’ve really seen that fall off as our customer base and our dealers have anticipated the introduction of SCR into this segment. So that’s been a drag on us, and that’s why you really haven’t seen the overall class 8 accelerate as much as we had hoped it would by now also. So that’s why we’re encouraged by what’s coming forward.
And what we have done, I’d maybe ask Jack to comment, the selling process in even the traditional class 8 tractor for us has been somewhat driven by, thank heavens we kind of started this, a demo program. You know, getting units into our customers’ hands and letting them test them. And obviously they want to test them for some period of time.
So although a little slower than we thought, I think every place we’ve provided the demo fleet or the demo units, we are turning those into sales. And those sales, by the way, are more meaningful for us, because in the sales proposition, we’re debating the relative merits of the units versus the competition, which is exactly where we want to be.
The process here for us, throughout this year and the end of last year, was really a seeding process, the ability for us to get in front of customers, to provide our ProStar with an [ISX] engine or a ProStar with our MaxxForce 13 SCR engine, really do a head-to-head comparison on really three factors, one being fuel economy, another being uptime, and another being how the drivers are reacting to the various vehicles.
And in the areas where we can have that kind of a fair-based comparison, we fare very well, and we’ve been able to demonstrate that success. But it’s a tough competitive market. Our competitors are good, and customers are very demanding. So this is a process that’s just going to take time.
Our next question comes from Jerry Revich of Goldman Sachs.
Jerry Revich - Goldman Sachs
Can you just talk a little bit about what you’re seeing on the pricing side, now that industry lead times are rising? And then on margins specifically, can you touch on what the impact of trade-ins has been on margin, how you’re thinking about that going forward?
As I said in my comments, the market is competitive from a price standpoint. I’m not sure that I would describe it as more competitive than it’s been, or less. This market has always been competitive from a price standpoint. And consequently, when you have excess capacity in the marketplace, and you have a desire from the competitive set to not yield on market share, there are price pressures in the marketplace. So every deal is different, every deal is negotiated individually, but overall, we do not take into our financial expectations that there’s going to be a windfall from price.
I think to emphasize something that Jack said there, the assumption that the market is increasing, and therefore delivery times are extending, which then might provide the opportunity for some price taking, at present, I don’t think we have seen that in the market. The market has not expanded at a rate that, as of yet, fully utilizes the available capacity between us and our competitors. And so we have not seen the ability to compete, per se, on shorter delivery times, which might give us the opportunity to mine that as pricing.
If the market continues to recover, and continues to grow, certainly that’s a reasonable expectation, but the growth that the market has experienced so far has not really resulted in that phenomenon.
Jerry Revich - Goldman Sachs
And the second part was just wondering if you could touch on any impact trade-ins may have had on margins in the quarter, and how you’re thinking about that as we progress over the course of the year.
I guess I’m not sure that it really sticks out in our financials. The impact of used trucks on our business is something we’re very focused on. As we said, we had a very good sales quarter, but receipts came in also. We work very closely with our dealers and with our customers on maximizing the value of our used trucks in the marketplace through our reconditioning center.
Yeah, I think that’s just going to be something that’s on us to manage as we go forward. We have - as do all of our competitors - every reason in the world to be interested in the value of our used trucks. That’s why we created Diamond Renewed. That’s why we have OnCommand Connect as a standard feature in the Diamond Renewed products. That’s why we have the reconditioning center. We believe that we have a very competitive used truck product in the market, and the prices that we get for those trucks seem to reflect that, and have not created a significant drag on our earnings at this point in time.
Our next question comes from the line of Ann Duignan with JP Morgan.
Ann Duignan - JP Morgan
Just back on the used equipment, can you talk a little bit about your inventory of remanufactured used trucks? And given everything we’re hearing out there about demand for used equipment, and the value of used equipment, what is your current inventory of the [remanned] trucks? Do you have excess, or none? Or do you have about what you expected? I’m just trying to get a sense of whether the marketplace is accepting of those remanned or whether we’re putting all this cost into these vehicles and still can’t find a home for them.
Well, I think we’ve actually sold 5,600 of those units into the market. Last month was a record sales month for us. The month before was a record sales month for us. So with this Diamond Renewed effort, it’s really an entire used truck strategy that we have. We recognize the need to turn these units. We did take in more units than we sold in the quarter, but we kind of highlighted that all to you guys last quarter, I believe, where, given the timing of some of the sales and trade-ins that we took, that our used truck inventory would go up.
But it actually went up a little bit, actually it was a little bit less than we had thought in the quarter. But it did go up. That’s actually the piece of data that I was looking for, and I don’t want to quote a number to you without looking at that. But we’re certainly willing to share that with you, but I can’t put my fingers on it right now. I’ll get you that.
We have cranked up our ability to sell used trucks, the [unintelligible] processing center is a part of that effort. We are working hard to preserve price and turn those trucks faster. So far, our tactics, we believe, are working. Used truck inventory went up in the quarter, but not out of line with our forecast, given the trades we had lined up from our sales activity.
So something we’ve got to watch all the time. I’m not trying to indicate to anybody on the call that this is like falling off a log. No, this is something we work at every day, and I would tell you that the level of intensity and focus within the organization on making this work for us is very high.
Ann Duignan - JP Morgan
And just on the $1,400 [unintelligible] on the [unintelligible] SCR, what’s holding that up? Why can’t we, with the click of a finger, get those costs out? What has to happen? Help us understand the process you’re going through in order to achieve that $1,400 cost reduction.
The components that we’re talking about are considered components of the emissions system. When you change the emissions system on a vehicle, you actually have to revalidate the vehicle with the EPA. You have to recert that engine, not the vehicle, in the truck business, it’s recert the engine, with the EPA. To recert the engine, there’s certain requirements. You’re actually certifying an engine that would have up to 430,000 miles on it, or something to that effect.
So you’re developing aged components, or you’re going to the field and pulling off components that are high mileage, and you’re physically putting those on engines, running them on dynos, getting the data, submitting it to the EPA, answering their questions, and then they’ll do that.
So we’re well into that process. But that’s the reason why it takes that time. Typically, we did it in record time, I think, when we brought SCR onto our 13 liter engine, but still, it’s like an 11 month process, I think. And so that’s the reason why it takes so long.
It’s not a technical solution. We have dozens of these engines. We’re running the daylights out of them. We understand the performance, we’re running field testing as we speak - our head of engineering is just across the table from me. It’s really just getting through the recert process. We don’t anticipate any difficulties on that, by the way.
Ann Duignan - JP Morgan
And that’s what I was getting at, I guess. I just wanted to understand that there were no real technical complexities there, that it’s just a timing issue.
We’re kind of excited about it, to be very honest.
Our next question comes from the line of Steven Fisher with UBS.
Steven Fisher - UBS
Really encouraging progress on the structural cost savings. But could you speak a bit more on the Lean initiatives? Maybe just what inning the Lean implementation is in, and not to get into 2015 guidance yet, but maybe high level, how you’re thinking about your ability to continue finding additional cost to take out next year.
If you are a real Lean adherent, and we’re very fortunate to have a number of those people in our organization, they would tell you that we are like, at best, in our manufacturing operations, in the second inning of a four inning game, that there are lots of opportunities for us going forward as we increase the knowledge level and as people go through cycles of learning, and as we’re able to actually invest in our facilities to be able to implement some technology that supports Lean concepts, like [unintelligible] and decoupling. For those of you who follow manufacturing, you’ll kind of know what that means.
In our headquarters operations, I would say we have pockets of excellence, but realistically, we’re probably still in the first inning of that four inning game, and still in the process of increasing the knowledge base.
I would tell you, it’s the kind of thing, though, that if this time last year you had said, from your Lean implementation, would you have expected to overachieve your SG&A as much as we have this year? I would have said no. Quite frankly, it’s one of those things that the more you do it, the more opportunities you find to eliminate waste and improve processes.
And it’s not a management initiative. It’s obviously a management led initiative, but it’s really about getting a couple of thousand people grinding every day, picking up a dollar here and a hundred dollars there, and you kind of add it all up, and you find your processes get better, your quality gets better, and the costs kind of fall out of the bottom.
So having been, in my personal career, through this type of Lean transformation in the past, I’m very optimistic that there’s a lot more to be had here. It’s difficult for us to probably see some of it yet, but it is one of those things, the good news continues to happen every day.
Steven Fisher - UBS
I guess for a follow up, shifting over to OnCommand, first, I missed some of the metrics you gave, how many customers and trucks are using the systems today, but I guess my bigger question is do you know what percent of the trucks using the system are your own? And I guess I’m curious if you can see how your uptime compares to competitors, and maybe if your engineers can use some of that data to tweak design.
We’re currently monitoring about 45,000 vehicles today. I don’t have the exact numbers, but the majority of those are our vehicles, because clearly we can provide a much better diagnostic solution to our vehicles. We do monitor competitive vehicles, but from a population or trying to do statistical analysis, that’s pretty difficult. What we’re really trying to do here is provide the customer better information to be able to improve their overall uptime of their vehicle.
For our vehicles, we can do the diagnosis much faster, we can communicate with the dealer, we can see the parts availability, we can see what the repair times are. And all of that is really a Lean initiative. We are taking waste out of the overall system with OnCommand Connect. So we’ve got a number of evolutionary type enhancements to this coming forward. We’re learning more every day as our customers, but we’re very excited about it.
Our next question comes from the line of Andy Casey with Wells Fargo.
Andy Casey - Wells Fargo
First, I wanted to go back to a comment I believe Jack made, and better understand the customer mix shift to larger customers. Do you think that’s an industry trend, or is it just normal quarter to quarter variance? And then are you starting to see more of your share regain at large fleets, including leasing fleets, that may be offsetting some volatility elsewhere?
Let me answer it a couple of ways. Relative to the quarter, we did have, for us, an abnormally high level of fleet mix within the quarters, as Troy had indicated. From a broader general statement about the overall industry, we do believe that there will be, in the industry, an overall higher mix of large customers.
And it’s really just driven by the economics of the market today and the ability for smaller customers to be able to compete, it’s going to be more and more difficult with the level of cost and regulations that are being put on the fleets. But that’s kind of more of a longer term trend that we’ve seen, and we do think we’ll continue to experience.
The other piece that has impacted us here is, you know, when you look at class 8, you have two components of it. You have the on-highway segment, and you have the vocational segment. The vocational tends to be much smaller customers, even in many cases one at a time or three trucks at a time, where the on-highway segment is far more concentrated toward larger customers.
And with us just introducing now the SCR versions on our vocational products, we saw that mix change for us within the quarter also, that we just had a higher portion of on-highway trucks versus vocational trucks. And we’ll see that again in the third quarter, but that will normalize over time.
Andy Casey - Wells Fargo
And if I could probe a little bit on the medium duty, the class 6 and 7, are you seeing a shift to regaining share in some of the large leasing fleets?
Our share growth is really across the board. We’re doing well with large customers, with leasing fleets, but also our dealers are having success in their individual markets also.
Andy Casey - Wells Fargo
And then if I could sneak another one in, it’s kind of a longer-term question about the 8% to 10% EBITDA margin. My guess is when you laid that out, the exit rate now of fiscal 2015, some of the South American issues that the business, global operations, is encountering, probably weren’t totally anticipated. How important is global operation improvement to hitting that exit rate, meaning can you get there without higher volumes in Brazil?
That’s why we’re very anxious to get through the restructuring and drive our breakeven point down as quickly as we can, so that hopefully Brazil’s performance is not a negative factor as we run to the end of 2015. I think there’s time for us to do that.
The second point that I would make, for this type of thing, not that we were clairvoyant, is why we suggested it’s a range of 8% to 10%, as opposed to a point performance. We know that there are things like this that will come up. And the comment that I had made, I think we certainly have the leadership capabilities, I think, to be more agile, more responsive, very fast, in how we think through these things.
And so these kind of aw shucks, one-time kind of things, they just need to be behind us by the end of 2015. And so I don’t anticipate the Brazil thing is going to be a big drag, or present a big risk to us at this point in time. But that somewhat depends on our ability to go down there and get stuff sorted out.
I mean, the people who analyze the Brazilian market, to include our own people down there, I think the majority of people think this is kind of a one-year phenomenon, and then we’ll begin to see some improvement. And at worst, it’s been reported that it’s maybe kind of a two-year phenomenon. There’s an election that takes place later this year, and typically, after an election, there’s some forms of economic stimulus in markets like Brazil.
But Brazil, for a long time, is up and down and up and down. And it’s really just part of the challenge of being involved in the global business. So yeah, I don’t think it is a big threat to the results that we’re pointing to at the end of 2015.
Our next question comes from the line of Joel Tiss of BMO.
Joel Tiss - BMO Capital Markets
Just kind of a clarification on the free cash flow. It’s about $175 million lower in this six months versus a year ago. Is that mostly working capital buildup? Or is there something else in there?
It’s mostly as a result of more than negative cash flow than that in the first quarter. So the first quarter, we had lower volumes, as we had highlighted, I think, already, in our fourth quarter call, that that would be the case. So we’re kind of digging out of that over the balance of the year now.
Joel Tiss - BMO Capital Markets
And maybe there’s enough information here. You’re probably not going to answer this, but the backlog’s building, the cost cuts are accelerating, you’ve got better visibility today than a couple of months ago. I wonder if you could give us any color or any idea if you think the 2015 free cash flow can be pretty close to breakeven. It seems like we’re getting really in that direction, but I just wondered if there’s anything you can give us in that area. That would be helpful.
Not today. Maybe we’ll think about that fourth quarter, as we start looking at 2015.
Our next question comes from the line of Jeff Kauffman of Buckingham Research.
Jeff Kauffman - Buckingham Research
I want to follow this theme of 2015, and I’ll do my best to ask just one question. As we look to 2015, most truck fleets kind of decide what they’re going to order in the fall, and then put those orders in the winter or the spring. So I’m thinking more of our market share gains are more likely to be seen in the 2015 budgets than the 2014 budgets. And have you thought at all about plans for the Blue Diamond related assets post the wind down of that?
That was two questions, Jeff. [laughter]
We have put in 22% to 24% market share in the way we’ve laid out 2015, in our chart here. And that’s really reflective of what you’re saying. It’s progressive growth. Throughout the end of 2013 and into 2014, we’ve seeded a lot of trucks with a lot of different fleets, and it’s our expectation, as we move into 2015, that we will garner a larger share of each individual customer that we do business with, of their business, based on the results they’ve seen in 2014, with our vehicles.
And the fall selling season, we are planning for that as we speak, because you’re exactly right. It’s a very critical time for us, from an order intake standpoint. I’ll let Troy talk about Blue Diamond.
Well, with regard to the Blue Diamond, Jeff’s reference, for the other folks on the call, is to the you probably saw the Wall Street Journal article here a couple of weeks ago with regards to Ford starting up their medium duty truck activity in the U.S. Those trucks had previously been produced in a joint venture between Ford and ourselves that existed in our Escabedo, Mexico plant, called Blue Diamond Truck.
And we’ve had a line of sight on this, and actually a lot of dialogue, with our partners at Ford for over a two year period of time. So this is not something that’s been unexpected, and not something we have not been able to plan around. That line in Mexico builds not only medium duty trucks for Ford, but also builds medium duty trucks for Navistar. And so we do have plans for how to use those assets going forward, and quite frankly it provides additional production capacity for us going forward as well, and gives us the opportunity to rationalize where we build certain products to reduce our logistics costs, so we can ship from different sites.
So yeah, we do have plans on that. They’re the types of plans I think you would expect. Hard to describe in a couple of minutes, but the capacity will be well utilized, and it’s been a good venture for us, by the way. And I think it’s been a good venture for our Ford partners, and I think we’ve had a really good line of sight on this for a while.
Please don’t confuse this with the other piece of the joint venture we have with Ford, which is called Blue Diamond Parts. Blue Diamond Parts, which largely provides service parts to the power stroke engine series, continues as a joint venture between the two of us. And that income is largely, I think, accounted for in our parts business. It’s not a separate business.
Our next question comes from the line of Adam Uhlman with Cleveland Research.
Adam Uhlman - Cleveland Research
Just a couple of clarifications first. Jack, I might have missed it, but what was your share of combined class 8 orders in the second quarter?
I don’t think I said it. I can tell you what it is. For the second quarter, they’re telling me it was 15.9%. That was retail business. 16.1% was the orders.
Adam Uhlman - Cleveland Research
And then when we think about the 9/10 engine that starts to be introduced over the next couple of months, how much of the class 8 business do you think that that can represent, and how much have we lost up into the 13 later or into the smaller engine?
As I recall, the vocational piece of class 8 is about 30%. So two-thirds of the market is on highway, and about a third of the market is severe service. And within the severe service or the vocational market, the 9/10 is the predominant engine. Virtually all of that market is that size, that engine. So that should give you some feel for what the impact can be.
Adam Uhlman - Cleveland Research
And then just lastly, as you’ve been taking up the build rates, I’m wondering what kind of supply chain constraints, if any, you’ve been seeing yet, or any anecdotal evidence of that down the road.
We monitor this very closely. We expected this increase. We have a very tight group of key suppliers that we work with all the time. Fortunately, we’ve not seen anything that is constraining production. We have spot shortages, but it’s things that are overcome. But we’re watching a handful of components here, but we don’t think it’s going to have any impact on industry levels where we are now.
I mean, think about it. We’re really just going to build this year, at 2012 levels. You know, 2012, the industry was about 230,000. It came down in 2013, and now we’re just going back to 2012 levels.
Ann, if you’re still on the phone, I did find the number I was looking for, and I just wanted to share it for everybody. At the end of Q1, we had $199 million worth of used truck inventory. We had indicated that that would rise, and at the end of Q2, it rose to $210 million. It’s actually a couple million less than actually what we had originally forecast. I’m not sure we shared the forecast with you, but well in line with the planned activity in that segment that we took.
The second thing I’d like to just say to everybody on, I apologize for, during the question and answers, if you heard some papers rustling. As your questions have become better and more focused, we strongly believe we owe you better and more focused answers. And so we are taking that opportunity to reach back and try to give you as many meaningful numbers as we can. That helps you do your job. So I apologize for the papers rustling, but I hope that some of the data we’ve provided is helpful.
Operator, I think we’re ready to conclude the call.
Great. I’d like to hand the call back over to Heather Kos for any closing remarks.
Thank you, everybody, for joining us today. If you have any follow up questions, you can get ahold of Randy [unintelligible] and myself. We look forward to talking to you.
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