David S. Graziosi - Chief Financial Officer, Principal Accounting Officer, Executive Vice President, Treasurer and Assistant Secretary Lawrence E. Dewey - Chairman, Chief Executive Officer, President, Chairman of Executive Committee, Member of Nominating & Corporate Governance Committee and Member of Government Security Committee.

Ross P. Gilardi - BofA Merrill Lynch, Research Division Andrew Kaplowitz - Barclays Capital, Research Division Jerry David Revich - Goldman Sachs Group Inc., Research Division Jamie L. Cook - Crédit Suisse AG, Research Division David Leiker - Robert W. Baird & Co. Incorporated, Research Division Neil Frohnapple - Longbow Research LLC Lawrence T.

De Maria - William Blair & Company L.L.C., Research Division Alexander E. Potter - Piper Jaffray Companies, Research Division Thomas Robb - Morgan Stanley, Research Division Timothy Thein - Citigroup Inc, Research Division.

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's Second Quarter 2014 Earnings Conference Call. My name is Melissa, and I will be your conference operator today. [Operator Instructions] As a reminder, this conference call is being recorded.

[Operator Instructions] I would now like to turn the conference over to Dave Graziosi, the company's Executive Vice President and Chief Financial Officer. Please go ahead, sir..

Thank you, Melissa. Good morning, and thank you for joining us for our second quarter 2014 results conference call. With me this morning is Larry Dewey, Allison Transmission's Chairman, President and Chief Executive Officer.

As a reminder, this conference call, webcast and the presentation we are using this morning are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through July 31.

As shown on Page 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectation.

These forward-looking statements are subject to known and unknown risks, including those set forth in our second quarter 2014 results press release and our annual report on Form 10-K for the year ended December 31, 2013, and uncertainties and other factors as well as general economic conditions.

Should one or more of these risks or uncertainties materialize or should underlying assumptions or estimates proved incorrect, actual results may vary materially from those we express today. In addition, as noted on Page 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC.

You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached as an appendix to the presentation and to our second quarter 2014 results press release, both of which are posted on the Investor Relations section of our website. Today's call is set to end at 9:00 a.m. Eastern time.

[Operator Instructions] Now I'll turn the call over to Larry Dewey..

Thanks, Dave. Good morning, and thank you, all, for joining us today. Our second quarter 2014 results are within the full year guidance ranges reaffirmed on April 16.

Net sales improved on a year-over-year basis for the third consecutive quarter, led by the continued recoveries in the North America On-Highway and Off-Highway end markets, partially offset by weakness in the outside North America end markets.

Allison continued to demonstrate strong operating margins and free cash flow, while aligning costs and programs across our business with end markets demand conditions and growth opportunities.

During the quarter, Allison continued its prudent and well-defined approach to capital allocation by returning capital to its shareholders through a $150 million share repurchase and payment of a dividend.

We are updating our full year net sales guidance to an increase in the range of 4% to 6% year-over-year due to anticipated improvements in second half demand conditions in the North America On-Highway and Off-Highway end markets, weakness in the outside North America On-Highway end market and previously-contemplated reductions in U.S.

defense spending. Please turn to Slide 4 of the presentation for the call agenda. On today's call, I'll provide you with an overview of our second quarter performance, including sales by end market. Dave will review the second quarter financial performance, including adjusted EBITDA and adjusted free cash flow.

I'll wrap up the prepared comments with the full year 2014 guidance update prior to Q&A. Please turn to Slide 5 of the presentation for the Q2 2014 performance summary.

Net sales increased 4.7% from the same period in 2013, principally driven by the continued recoveries in North America On-Highway and Off-Highway end markets and higher demand in the Service Parts, Support Equipment & Other end market, partially offset by lower demand in the Outside North America end markets and previously-contemplated reductions in U.S.

defense spending. Gross margin for the quarter was 44.5%, an increase of 30 basis points from a gross margin of 44.2% for the same period in 2013. The increase in gross profit from the same period in 2013 was principally driven by increased net sales and price increases on certain products, partially offset by unfavorable material costs.

Adjusted net income increased $28 million from the same period in 2013, principally driven by increased adjusted EBITDA and decreased cash interest expense. Adjusted free cash flow increased $15 million from the same period in 2013, principally driven by increased net cash provided by operating activities.

Please turn to Slide 6 of the presentation for the Q2 2014 sales performance summary.

North America On-Highway end market net sales were up 13% from the same period in 2013, principally driven by higher demand for Rugged Duty Series and Pupil Transport/Shuttle Series models, and up 4% on a sequential basis, principally driven by higher demand for Rugged Duty Series and Pupil Transport/Shuttle Series models, partially offset by lower demand for Highway Series models.

North America Hybrid-Propulsion Systems for Transit Bus end market net sales were up 4% from the same period in 2013 and 17% sequentially, principally driven by intra-year movement in the timing of orders.

North America Off-Highway end market net sales were up 188% from the same period in 2013 and 92% on a sequential basis, principally driven by higher demand from hydraulic fracturing applications.

Defense end market net sales were down 16% from the same period in 2013 and up 44% sequentially, principally driven by previously-considered reductions in U.S.

defense spending to longer-term averages experienced during periods without active conflicts, partially offset by the recognition of previously-deferred revenue totaling $16 million, commensurate with the shipment of certain tracked transmissions at the request of the U.S. government.

Outside North America On-Highway end market net sales were down 17% from the same period in 2013, reflecting weakness in China, Western Europe and South America, and down 3% on a sequential basis, reflecting weakness in China, partially offset by Japan.

Outside North America Off-Highway end market net sales were down 33% from the same period in 2013, principally driven by weaker demand conditions in the energy sector, partially offset by higher demand from the Mining sector and up 14% sequentially, principally driven by modestly improved demand conditions in the energy sector.

Service Parts, Support Equipment & Other end market net sales were up 16% from the same period in 2013 and flat on a sequential basis, principally driven by higher demand for North America service parts and North America on-highway support equipment, commensurate with increased transmission unit volumes.

Now I'll turn the call back over to Dave Graziosi..

Thank you, Larry. Please turn to Slide 7 of the presentation for the Q2 2014 financial performance summary. Given Larry's comments, I'll focus on other income statement line items and adjusted EBITDA. Selling, general and administrative expenses were $85 million, essentially flat with the same period in 2013.

Engineering, research and development expenses decreased $2 million from the same period in 2013, principally driven by reduced product initiative spending.

Interest expense, net, increased $3 million from the same period in 2013, principally driven by less favorable mark-to-market adjustments for our interest rate derivatives, partially offset by debt repayments and lower rates for our LIBOR swaps and senior secured credit facility.

Other expense, net, decreased $2 million from the same period in 2013, principally driven by gains on derivative contracts and favorable foreign exchange, partially offset by lower grant income.

Income tax expense for the second quarter of 2014 was $38 million, resulting in an effective tax rate of 40% versus an effective tax rate of 38% in the second quarter of 2013. The effective tax rate increase was principally driven by the change in discrete activity.

Adjusted EBITDA for the quarter was $186 million or 34.7% of net sales compared to $172 million, or 33.5% of net sales for the same period in 2013. The increase was principally driven by increased net sales, price increases on certain products and reduced product initiatives spending, partially offset by unfavorable material costs.

Please turn to Slide 8 of the presentation for the Q2 2014 cash flow performance summary. Allison continued to demonstrate solid free cash flow conversion and a well-defined capital allocation policy focused on the return of capital to shareholders, while pursuing a prudent level of net leverage.

Allison ended the quarter with $127 million of cash, $453 million of revolver availability and net leverage of 3.82. Now I'll turn the call back over to Larry Dewey..

Please turn to Slide 9 of the presentation for the full year 2014 guidance update.

Our updated full year 2014 guidance includes a year-over-year net sales increase in the range of 4% to 6%; and adjusted EBITDA margin, excluding technology-related license expenses, in the range of 32.5% to 34%; and adjusted free cash flow in the range of $385 million to $425 million; capital expenditures in the range of $60 million to $70 million; and cash income taxes in the range of $10 million to $15 million.

In the second half of 2014, we expect net sales to increase on a year-over-year basis, principally driven by improved demand conditions in the North America On-Highway and Off-Highway end markets, weakness in the Outside North America On-Highway end market and previously-contemplated reductions in U.S. defense spending.

Although we're not providing specific third quarter 2014 guidance, Allison expects net sales to be higher than the same period in 2013.

The anticipated year-over-year increase in third quarter net sales is expected to be principally driven by higher demand in the North America On-Highway and Off-Highway end markets, partially offset by previously-considered reductions in defense net sales. Melissa, please open the call for questions..

[Operator Instructions] Our first question comes from the line of Ross Gilardi with Bank of America Merrill Lynch..

I just had a couple of questions. First, I think you're at about 3.8x leverage right now and on our numbers you're at about 3.5x by year end '14 and I think that probably be where consensus numbers would be too. So it seems like only a matter of time before you're at your 3 to 3.5x leverage target.

Is it just a matter of crossing the threshold on 3.5x before you begin returning cash more significantly? Would you rather be near the lower end of the range?.

I think there's a number of options that we're looking at, Ross, for the capital allocation going forward. As you know, we've indicated to the market the 3.5 level at the near-term target. Having said that, we're constantly evaluating our capital structure and the debt markets, and I would certainly submit that.

Our focus remains getting cash back to shareholders, the ultimate form we look to further refine here over the next 6 to 12 months with -- in conjunction with the board, and I would look for us to come out with some more specific guidance on that as the second half evolves..

Okay. Great. And then obviously, you guys don't give long-term earnings guidance, but I was just curious on sort of what your overall feelings are on the sort of the multiyear directional view on North America On-Highway.

I mean unlike the heavy-duty Class 8 market, it seems like you've got a longer, more gradual runway to grow in that market over the next several years.

And would you generally agree with that statement? And then, any granularity you could provide on what you're seeing in the different end markets?.

Sure. Number one, we do, in fact, see a longer runway on it more gradual as you've described it in particularly in the medium duty and Class 8 straight truck, which is of course our relevant markets.

Even the short haul is probably less volatile than the line haul, where we sell some of our highway series, and of course we're bringing our TC10 into that spaces as well and getting some traction on that here relative to interest and some orders flowing in.

Now if you look across the various sectors, the end markets of our business, I think we're seeing some improvement, municipal, it's not all the way back. There's still some people fighting through some tax receipts issues, particularly some of the more challenged municipalities. But we're continuing to see improvement there.

Certainly, some of the commercial lease rental, consumer rental business, that's been strong, some of the package delivery business has been strong. There's 1 of our OEMs has gotten some significant additional business from I believe it's UPS, I saw on some of the notes. And so, certainly, that's moving our way.

One that hasn't had, and I'm not suggesting that it's a huge uptick, but has actually seen some improvement from some very depressed levels, is the motor home market. We've actually seen some -- a little bit of uptick there as well here in North America. The other thing that's going on in North America is in the bus space.

Transit business, for the conventional products, I think we've seen some nice business there, including some where -- we're getting some interest from some fleets that's have been long-time users of some of the competitive products.

And that's something that certainly we're responding to and frankly want to understand some of their interest and what the basis for that is, so we can continue to push even harder at some of the fleets maybe that haven't yet stepped forward that have been using some of the competitive products.

So there's a number of areas where we feel good, but there's always work to do. We got to make it happen. There's some penetration we've gotten in construction.

We've had some targeted programs here through the first 3, 4 months of the year focused on non-user conquest selling and have been successful placing small quantities, frankly, because it's the trial basis, they try [ph] as we've talked about on a number of calls.

But nonetheless, there are a number of fleets that for the first time ever are using Allison's in their fleet, and we're confident and -- that as they get that experience, we'll be able to persuade them between the product performance attributes and the support that we provide.

We would expect that a number of those would continue and indeed expand their purchases and that's why we do those programs..

Our next question comes from the line of Andrew Kaplowitz with Barclays..

Larry, can you break down where the weakness was a little bit more in non-North American On-Highway? Obviously got some -- a bit worse here in 2Q versus expectations. We know Europe was weak, but maybe talk more about China and then Russia, Venezuela, some of the small pieces.

And then, just real quickly, like I know your guidance was -- you probably don't want to go over specific guidance on this particular segment, but it was plus 10, obviously it's not going to be that.

Is something like down mid-single digits, is that how we should think about it for the year?.

Yes. Let's take a quick tour around the world and let me start out by saying, clearly, there's some headwinds that one could argue are beyond our control. Certainly, geopolitical events involving Russia is not something we control.

That said, I do think that there are some things that we can do, and I'll be spending some more of my time in this space to make sure I'm providing the appropriate level of encouragement and support for the initiatives.

But if you go around the world, Russia, we are feeling very good about the release activity and some of the groundwork that had been laid and obviously with some of the events.

Frankly, a lot of things were already seizing up in Russia truth is, not even necessarily tied to the sanctions, just to the consequences of some of the sanctions and some of the loss of business confidence over there. So that's one that we've spent a couple of years on and really felt like we were poised to start breaking out in '14 and beyond.

And that's certainly disappointing, and beyond that I won't offer any further commentary. We'll obviously follow all government dictates and be within the law and we'll have to wait until some of the relations are a little more normalized, I think. Turkey was one I should have mentioned.

I mentioned Western Europe being a little soft, and I'll come back to that. But Turkey is one where we've done some nice work in bus sales there. That's another one where it's gotten a little choppy as a result of some allegations of corruption, again not involving us, but some of the government folks.

So that's really dried up a bit here, not unlike the situation we had in India for a couple of years, unfortunately. So we feel good about our positioning, but the market's bound up a bit. China, you got the bus. I think we're still well-positioned there. That really goes to some of the tenders. Two things.

Number one, they have kind of made a I'll call it, a near-term trial order. Some of the tenders have been converted to domestic electric, I'll call it, vehicles. Certainly where -- we've got some product that we'll be looking at here into that space.

I think they're going to be challenged based on the duty cycles with the batteries, battery life and performance. But nonetheless, when the government there says we'd like to take a step in this direction, the fleets follow that here, and that's happened to a couple of near-term tenders.

We haven't really, in that sense, I don't think lost any conventional positioning, but they certainly have -- there's one significant tender that's gone that way. Beyond that, I think we're well-positioned. Truck, we're gaining, but frankly not at the pace that we had originally budgeted.

So on one hand it's -- you can see some of the progress and I would expect that to accelerate as a result of some organizational changes we've made. But nonetheless, that's not meeting the targets we had set, even though they're making progress.

India, we're starting again to see things break loose, so that's good, but a little later and a little smaller than what we had in the original plan. So again, kind of a sweet and sour situation there. I think that will come to us. It's a question of the timing of some of the tenders and just how much business is going to flow.

Again, we feel good about the positioning there. Argentina and Venezuela and Latin America, I think we're all familiar with the situation there. That's a -- not an insignificant couple of markets for us, and those have obviously had, had some problems.

Touched on Western Europe being slow, and I think that we had not properly understood at the end of '13 exactly what prebuy had occurred.

The other issue in talking with one of the large Germanic OEMs that we do business with, they indicated that in the municipal, largely municipal over their space and some of the private fleets as well, some of there we might call it severe service, heavy vocational type vehicles where we typically play, that they're anticipating about a 25% year-over-year down take in that space.

So that's something that we're trying to factor into our numbers as we go forward. On the plus side, Australia has probably come back a little quicker than we would have thought in terms of the macros. So that's been a nice piece and some of that flows through Japan.

And in Japan, I think some of the work that's going on, geez, over roughly 3, 4 years here with end-users is finally starting to pay off on the domestic markets. So that's been a bright spot albeit of a lower magnitude.

So that's kind of an around the world kind of a view, and certainly your assessment of that year-over-year net result, given all of those headwinds, is probably not unreasonable.

And like I say, some of those things I can accept that there's some headwinds that are beyond our control, but we don't control wind, but we do adjust the sails, and so we've got some work to do..

That's very helpful. If you look at your 3 highest margin businesses, what you've said in the past, parts, North American On-Highway, North American Off-Highway, these are the businesses that are sort of leading the charge for you.

So why wouldn't your mix shift really help you from what was already a good first half of the year in terms of EBITDA margin? I mean, we understand the weakness in non-North America.

But still, it seems like you could get to the high end of the range as long as we see something like what we just saw in 2Q?.

I would say certainly with the pleased with the margin development in the second quarter as we pulled together our guidance for the second half, yet. As Larry indicated, certainly some of our visibility around outside North America continues to be a bit challenged.

North America, to your point, in terms of some of the higher-margin businesses, are certainly pulling in the right direction. Having said that, we also had some additional spending plans in the second half around our engineering group and some initiatives. Again, it's nothing different, frankly, from our usual process.

It's more of a cadence of the execution of specific initiatives. So there's heavier spending there as well. And I would say, on the SG&A side, some additional work that we're doing in the second half is, historically, you would see us ramp some of our spending related to marketing events, specifically, around the third quarter.

On a year-over-year basis, if you look at the second half last year, we also had some favorable experience in warranty that was recognized in the third quarter of last year that we're not at this point anticipating for the third quarter of this year. So a number of drivers there.

I would say as our positioning has been in the past, we pull together guidance, we take a view of certainly being prudent about the outlook at the same time. I would not necessarily disagree with your view that things could go a bit higher relative to our range there.

But we'll as we get further into the second half an update with third quarter, we can certainly revisit that..

Our next question comes from the line of Jerry Revich with Goldman Sachs..

Can you gentlemen just talk about within your pressure pumping business what was the parts performance like in the quarter. Just give us a sense for order activity as well. I guess based on what we're hearing, we would imagine your lead times are starting to widen out, but maybe you could give us an update.

And also, can you just touch on what's the order mix of your newly-expanded, high-end product lines and pressure pumping as well?.

Well, let me answer them in reverse order there. In terms of the new products, we've just seen some of the folks converting over. One of the things we're doing this time to make sure that the launch goes extremely well is we've queued up the rig engine pump combinations.

And in the past year, we've really advanced our state-of-the-art, relative to understanding the total rig system, with analytical models based on the data we've gathered.

And so with the new product before we will allow someone to use it and receive those benefits, we make sure that we go out and we instrument and we test the rig and essentially got to certify, if you will, the installation. So that process is ongoing. We do have units that have gone to China. We've got folks coming in on board here in North America.

Probably our largest single customer in that space, in the energy space, will be converting a little later this year as their rig configuration evolves to take advantage of some of the new capabilities of the new products. So that's kind of where we're at. We're pleased with the reception.

We think the customers are going to be very happy with the performance. It obviously takes us into a space with the higher horsepowers where we had not previously been. And so, we're kind of excited about that because that gives us a chance to go at it with some folks that are in that space currently.

Relative to the parts, the aftermarket net sales, of course, as you probably noted, your analysis is up sequentially, now 6 consecutive quarters and year-over-year, 5 consecutive quarters. We do see -- we have seen a surge here in the first half. We do expect the high level to continue. We don't expect the rate of increase to continue.

We think we're kind of -- we've reached at least in the near-term here kind of a terminal velocity, if you will, at this higher-level. So I wouldn't lay a straight edge on it. What I would do is if you did take that first half and laid a straight edge across, rather than on the increasing slope there.

We think that there could be -- we're watching closely some of the rigs that are exported here from North America. The average age of those is about 10 years.

They go to other places in the world where some of the duty cycles and regulations are a little bit different than here in North America, so we certainly want to be positioned globally for any potential service parts there as well. But that's kind of our take on the service parts piece of it, Jerry..

Okay.

And Larry, can you just provide some more color on what you're seeing on the applications in China, how's their pressure pumping ramp going? What are the run rates like? What does the part stream tell you about how they're being run? What are you seeing in terms of how successful the developments are there for the customers?.

We've -- it's interesting because very often in that market, whether it's On-Highway or Off-Highway, when you have a new initiative launched by an OEM, what you see is a very -- it's a very aggressive industry, I guess, I would say, where they have very aggressive plans.

And frankly, they put their money behind that in terms of building a bunch of product. And frankly, their ramps typically don't match the initial surge. And so you have kind of this binge and wean, I guess, maybe process. And we're kind of in -- we're still in what we think is the digestion process, maybe is a better way to say it, binge and digest.

We're still digesting in the energy space. They clearly have an appetite for higher horsepower. Some of that gets to some of the bridge laws we have in this country. Some of that gets down to the nature of the work in China. If it's remote and difficult to get to, it's a lot easier to get 8 rigs instead of 10 rigs there.

And so if you need x amount of horsepower to get the job done, you better have that kind of a greater ratio of horsepower on that rig when you get it to the sites. So that's one factor.

The other factor is, and there was an article, I think, in the New York Times here recently, that talked about how, by some estimates, the effort is 3x as hard as some of the other fields here in North America to extract the energy. So that again would imply a need for higher horsepower, which is lining up.

I mean, they were the first ones to -- in fact, we accelerated our production ramp to get them some units initially to get into the field to see how they like them. They were the first ones to come on board with some of the higher horsepower..

Our next question comes from the line of Jamie Cook with Crédit Suisse..

Just a couple of questions. One, you noted in your presentation and in your prepared remarks that material costs were higher.

Can you just talk about where it was relative to your expectations? And has your expectations for material cost changed throughout the year? My second question, could you just give a little color on what you're seeing in mining broadly? Any signs of hope there in terms of a bounce off the bottom? And then my last question, Dave, just to clarify, you answered the margin question related to Andy, but I just want to make sure, I think last quarter you said SG&A would be flat and engineering down slightly year-over-year.

Has your expectations for the year changed?.

Just a couple of things. In terms of your question on material costs, certainly, not that significant if you think for the quarter is roughly $3 million as you'll see when we file the Q. I would say overall expectations for the year really not that different from what we started with.

Our teams continue, I think, to make some good progress, frankly, on a number of supply chain initiatives. I think our global footprint, as we've talked before, provides us with some new opportunities relative to that space as well.

But there really isn't anything that significant and I think as Larry talked about, with managing schedules, lead times, we haven't seen anything significantly different, frankly, from what we expected coming into the year. On the SG&A, your question there, a couple of things.

As we have updated, frankly, our spending numbers and some of our programs, overall for the year, we also made some reclassifications within the P&L and you'll see that in the 10-Q in more detail. But certainly there, there is a reclass on a net basis in terms of the impact on EBITDA. There really isn't an impact, it's a reclass, as I said.

On the engineering side, we'll essentially be -- expect to be more or less flat year-over-year, as I said earlier. Some of the initiatives we have relative to product development is more weighted in the second half at this point, and that's just the cadence of how we rolled up the programs.

There isn't anything relative to push or delay or deferral on our part in terms of timing it more. It really has to do with the execution of those particular programs. But we certainly feel good about the status of those initiatives and the value that they potentially create and will deliver for the shareholders..

Yes, within that project engineering pieces, to add a little more color here, there's actually -- we've been able to increase some scope even within the numbers.

We're continuing to do more work in the horsepower, expanding our horsepower upwards in the Off-Highway space, continue to do refinement work with the H3000 as even as we feel that some prototype units. So there's -- pleased with what engineering is getting done.

And then of course, our other -- our Fallbrook and our Torotrak, that's really purely timing. That continues to be within the scope that we had outlined. So that's -- we feel pretty solid that we're getting some good things out of the product folks.

As far as your comment about the Mining, it would be fair to say that certainly, we do continue to say that the rebound is sluggish, that might be a nice way to say, almost nonexistent in a number of areas. From the standpoint of the Allison business, probably 2 significant pieces.

Certainly, one of our large European customers which was acquired by Volvo Construction Equipment, and they are understandably looking over their inventory policies, and so I think they're drawing that down a bit, which results in some near-term lower requirements as they bring inventories more in line with what the new ownership would like to see.

The second one is -- and this kind of gets back to some of my comments about the China market in general. And certainly it applies in this space. One of the key horses we're riding in China in the Off-Highway space, Off-Highway Mining is Sany.

They've certainly made it known what their intentions are and have opted for Allison products in their portfolio. They were very aggressive in ramping up their production build, and they haven't been able to take all of those vehicles into the market at the pace that they would have liked.

So then they have, in turn, reduced their schedules here, the rest of the year as they continue to build their volume of vehicle sales..

Our next question comes from the line of David Leiker with Baird..

Just a couple of quick follow-ups here. On the international markets, Larry, as you went through, I don't believe I heard you talk about Europe in total..

I'm sorry..

I don't think you talked about Europe in total what was going on in the market there for you..

Well, I guess a couple of things, and I'll speak -- talk about Turkey, okay. The other one I didn't mention was South Africa as a result of some of their -- some of the challenges they've had down there, the Mining market which uses -- those vehicles use a variance of our On-Highway products, Rugged Duty Series, the articulated dumps out of Bell.

That's certainly been challenged. And then in the On-Highway space, the -- some of the labor strikes have had an impact on some of the general economic conditions there. So that hasn't been helpful. Talk a little bit about Turkey, talked a little bit about Russia.

Western Europe, I've touched on that relative to the prebuy that -- certainly in the first quarter and in the first half here has impacted us a little bit. And then comment on the what I'll call the rugged or the more vocational applications, construction, some of the refuse, et cetera, where we have a position in Europe.

One of our larger Germanic OEMs has indicated that their volume is going to be down 25% for the year relative to the reduced level of business. So that would be kind of my high-level summary around what we call our European, Middle, East Africa region..

Okay. Great.

And then can you just give a little bit of color on where you are with the TC10 and the launch and what the acceptance has been? Some characterization of where volume might be?.

Sure. Well, as you know, the products offered with Navistar and their ProStar and TranStar models with their MaxxForce '13 engines. We have started to see the deliveries going to customer. We received our largest order to date, 50 units in 1 swoop here with a particular fleet. So we think we're starting to build some momentum.

We've got now 130 customer fleets that have tested the product. A number of them have ordered, others have expressed an interest. It's a little bit like that. Certainly, some of the feedback we've gotten has been kind of like that old Life cereal commercial where the kids weren't sure they wanted to eat it, they said let Mikey try it first.

And so there are people watching these pilot fleets pretty carefully. And we're confident that that's going to -- their experience as they share that in the industry or as people become aware of it, is going to be a positive one. We continue to work on understanding the fuel efficiency advantage over manuals and AMTs.

Frankly, that continues to come back very positive. We would now say you're probably confidently in the range of 5%. Previously, we were talking 3 or north of that. And we're certainly seeing continued good results in that space. So it's the ramp. It's that trial phase.

It's that -- let's see some and make sure we're comfortable with it before we make big purchases. But we think we're finally starting to pick up some momentum there, and we feel good about that..

And where are you at picking up additional OEMs for launching the product?.

Well, we're in very active dialogue and have initiatives that we have put forth to expand both the engines that we run behind, as well as the OEMs and their platforms. And I think, based on the feedback we had received previously, I think that we are much better positioned relative to getting some progress made on that.

We've made some recent offers to some folks to try to get them over the hump..

Is that something you think can fall into place here in the second half of the year there? Or is it a longer-selling cycle?.

I don't think it'll result in volume the second half of the year because in some cases there are some engineering integration work that would need to be done. It would probably take up the rest of the year. Certainly, we've placed incentives on the offers such that it would necessitate a fairly aggressive pace, let's put it that way..

Okay. And then lastly, just on the Military defense side. One of the companies we follow talked about a little bit of uptick in the orders in the quarter.

Do you have any sense that your volumes there are stabilizing where they are at all?.

No. I think that we would continue to say -- I mean, it was we're up compared to the plan, and that's been true in each of the past years. But the plan, overall, I mean the big thing is bringing it down to more normal levels and what changes that is some timing. We've had people push orders out. We've had people pull them in.

We get the spares orders, those are virtually impossible to forecast because the folks don't know they're placing them until they do. So that tends to be -- they're not huge numbers in terms of the base plan, but it does, when you're dealing with small numbers, few hundred units, is not insignificant on a percentage basis.

But I would say, at this point in time, that we think the plan is prudent. And anything if we get some spares orders or a few additional vehicles drop in, one that we don't have a lot of visibility on, but we're well positioned for is anytime one of the U.S.

OEMs sells to a foreign government with all the necessary approvals, of course, that's something that we don't have a lot of visibility of and that rolls into the beauty of that is -- again, those products are variance on our commercial lines with much higher volumes and we can respond to those orders very quickly..

Our next question comes from the line of Neil Frohnapple with Longbow Research..

A nice acceleration in North America Off-Highway revenue during the quarter.

Have you really seen an inflection point in new rig order activity? And can we think about that as a new base for the remainder of the year? And I guess just as a follow-up, can you help us understand what a more normalized annual revenue number should look like for this business since we've seen some wide varying numbers the last few years?.

Let me talk to the second and come back to the first. The Off-Highway energy business, historically, and we obviously look to say, okay, this is how it's going to be going forward or is it going to stabilize.

I personally think that we're probably entering a period where absent significant shifts in policy, in as much as there's been some export channels opened up, I think you're going to see a more global dampening effect. I don't mean that in a negative way, I mean in terms of volatility. That's the world according to Larry Dewey.

And obviously, time will tell on that. Otherwise, under just a regional kind of a basis, historically, here in North America, it's been very, as you know, very cyclical. So it's kind of like saying the average temperature in Moscow is 72 degrees. The problem is it's 100 in the summer, and it's minus whatever in the winter.

We do think that we've reached an inflection point. We do have -- obviously, you could see from the numbers, the transition and the improvement. And frankly, we have inquiries coming in that would suggest that that's going to continue and indeed build on itself as we talked about with the recovery.

So we do feel solid on that, and we think that -- sometimes I guess -- I had a boss who used to say, sometimes you like to be lucky as well as good. Our timing was fortuitous relative to the introduction of our new higher horsepower models. It's well positioned in the space and I think, competitively, has been well-received..

Great. That's helpful. North America On-Highway sales increased 4% on a sequential basis, but you call out lower demand for Highway Series models.

Could you just provide a little bit more granularity on this and where the weakness stem from or if it was just more from timing?.

In terms of the -- when we talk about Highway Series, make sure we're clear, we have a variety of models in the On-Highway space North America. And Rugged Duty Series, for example, goes in refuse trucks and construction, et cetera.

Highway Series is a model that we use relative to just strictly over the road, pickup and delivery, et cetera, and so, that's the space that we would say hasn't been as strong, although there is even a bright spot in there in what we call the Metro market, the 3000 HS again kind of an over-the-road application, lower torque and horsepower than the TC10 market.

For example, the 3000 HS, that's I think limited to 1,250 foot-pounds of torque. But there are some premium midrange diesels that go into the Class 8 space there, the baby 8, sometimes they're called. So that's been a good piece for us, whereas the TC10, that's targeted for 1400, 1450 and above, all the way up to 1750 foot [ph] power.

So kind of a bifurcation there of that market..

On the seasonality, I think just to add up to Larry's comments, historically with our business, when you look at first quarter, second quarter, there's a number of things that add some seasonality to our business, specifically around lease rental, package delivery, school bus, et cetera. So there's a number of moving pieces.

Those will all, for the most part, hit the Highway Series model that Larry referred to. So you just keep that in mind as you think about our volumes in the On-Highway business specifically for North America..

That's a great point. There was a time when it was even more lopsided, I can recall early on when I first came to Allison. I mean you'd see a 60-40 split maybe in terms of first half versus second half in the On-Highway space.

In fact, I had the privilege of coming into the plant that was most affected by that and things were pretty crazy in the second quarter, because you had all of the one-way rental fleets. They want their stuff on the road by Memorial Day because that's the busiest moving weekend of the year, apparently used to be anyway. So that's a good add there..

Our next question comes from the line of Larry De Maria with William Blair..

Just curious about just some of the potential moving parts in the market.

How do we think about Ford's decision to potentially enter [ph] transmissions in the future? What kind of impact we think about that? And when would you expect that to run to the P&L? And secondly, within the quarter, then more broadly, have you seen any impact from the AMT and straight trucks? Any kind of share shift? But from what we see, obviously your share had been pretty resilient.

Is that a fair comment?.

Second question first. We certainly, if anything, we think we're -- those that -- I would say that the shift at least in our addressable markets relative to AMTs, we feel we're well-positioned.

In fact, we think that probably some who have tried the product have seen some of the performance attributes and, if anything, we think that we've got some of that back from folks that tried some. Relative to the Ford, the Ford announcement, certainly, we anticipated that. What they're trying to do is take a variant to their automotive transmission.

They have integrated that transmission with their engine family for the automotive side. And so they don't have -- they've got the engineering work done, and they're attempting to go with obviously a vertically-integrated solution.

In addition to the Allison, they've also diluted the Cummins engine, which as you know, is the most popular offering in the medium duty space. So they're clearly -- essentially, if you summarize their strategy, we're going to attempt to offer a vehicle which may not have all the commercial duty attributes at a lower price point.

And so we have already began working. In fact, the week that they announced it, the show here, we also did an announcement with Freightliner, a program that we are working with other OEMs. They are going to Ford now. That's going to be effective here the end of the first quarter of '15, I believe, is the timing on that.

We've already begun working with end users who have been very pleased with the Allison working with the alternate OEMs to attempt to see if we can put together programs that would allow them to move. It would be a conquest sale for the other OEM and it would be a maintenance of the business that we've gained for Allison.

And so that's kind of the path we're on. We have a fairly aggressive marketing campaign, which is taking the differences in the products. We have a competitive analysis group that does teardowns and we've done some of that work, and we'll be sharing that with end users to demonstrate the difference.

And for those that are looking for the kind of commercial duty durability, we think that the Allison offering is going to be pretty appealing, particularly as we work with the other OEMs to come up with the an interesting total vehicle package offering..

Okay. That's great. And then secondly, on the cash flow, seems potentially conservative to us on a full year basis because if we look at run rate and the CapEx and the cash taxes.

Is there a reason why they might step up in the second half? Or are we thinking correctly that there could be some conservatism on the cash flow?.

Yes. On the cash flow taxes, historically, have been more -- cash taxes have been more weighted to the second half of the year just around the filing, return filing timelines, et cetera, and the estimated payment. So you will necessarily see higher level typically in the second half.

There's a number of moving pieces that obviously we've assumed in the cash flow forecast. One of the bigger drivers that you need to pay attention to is the U.S. government price reduction payments and the sequencing there.

As you'll note, when we file the Q, when you look at the breakdown of current liabilities, there's a 20-plus million dollar obligation that's sitting there that's current. That's a significant driver in terms of our assumptions around cash flow for the second half, certainly. Again, we have no control over the sequencing there and the timing.

So to your comment then on conservatism or otherwise, I would certainly say we provide the guidance we feel is certainly attainable. As we get further into the second half here, we'll update for the third quarter, but we're certainly pleased with the development of cash flow so far this year..

Our next question comes from the line of Alex Potter with Piper Jaffray..

You had mentioned a little earlier about a change in, I guess, your organizational structure in China or something, to try to address the lower-than-expected penetration of the truck market.

Was wondering if you could elaborate a little bit on what exactly you've changed there and when you might think you could see some results?.

We've brought in some mid-management leadership that has a better proven track record of delivering on increasing, and at the end user level, in particular, more demonstrated capability in selling the end user. We've got the releases.

As we've talked about in the past, now you secure the release, you promote the release of the OEM and you sell the end-user. And we've certainly done the first. We need to continue to iterate on the second point. And the third point is really where I would say that we need to step up our efforts.

And so we have changed some reporting structures to separate the bus from the truck more completely, have brought on some additional resource in the truck space to go after the end users and then brought in a more proven managerial leadership in that space..

Okay. Very good. That's helpful. You also mentioned here recently this 5% fuel economy benefit of the TC10 versus manuals and AMTs.

Is that -- what is it versus manuals and what is it versus AMTs? Or do you just kind of use a blended number?.

Really, frankly, depending on the duty cycle, you'll actually get some flip over between the 2. So we tend to use a blended number. Obviously, what we wanted to do is we want to get the customer to try it in their specific application and see what they're getting. We've got folks with numbers that approach 10%. We've got folks with numbers that are 2%.

Obviously, the higher, the shorter the payback..

Our next question comes from the line of Nicole DeBlase with Morgan Stanley..

This is Thomas Robb in for Nicole. I just had a couple final tie-up questions.

On the $16 million of deferred revenue on the defense segment, is there any EBITDA in with that?.

Obviously, the EBITDA is recognized when the sale is recognized. So the deferred revenue brings with it the associated EBITDA..

Okay. Great. And then on the -- just a little bit on margins.

How should we think about the sequential changes between 2Q and 3Q? And 3Q and 4Q? Are you guys anticipating any major differences between, I guess, second half and normal seasonality?.

We do have some seasonality. Historically, the fourth quarter feature is about 5% less work days because of the holidays, as you would expect there. But that has some impact on our fourth quarter results, historically, and I don't believe this year will be different.

From an overall standpoint, as I mentioned, we do have some initiatives spending teed up for the second half around, both product engineering, as well as our SG&A. Again, the seasonality is applicable there as well, more so on the product initiatives timing, frankly. But you will see that roll through relative to our guidance.

But beyond that, there's really nothing that significantly different from first half, second half..

Our next question comes from the line of Tim Thein with Citigroup..

We'll just squeeze 2 quick ones in, if I may. The first, Larry, on the global supply chain, you referenced this earlier.

I just wanted to come back and see actually where you stand in terms of utilization in both Hungary, as well as I guess what's relatively new facility in India? I'm just curious how much you've been able to push over there, especially in light of what looks like a -- maybe a little softer kind of international sales backdrop? So maybe just some help there..

Yes, one of the things that we have is tremendous scale here in the Indianapolis facility. So actually it presents a fairly attractive cost picture versus some of the low volume, although we do, for the long-term, have confidence that the lower fundamental structural cost in places like Hungary and Chennai will work out.

We have not shifted production locations on anything. In terms of utilization, we're running 1 shift in Hungary, virtually 1 shift full, give or take. And in India, we're on 1 shift, but we're probably not full on the 1 shift. So we've got considerable runway there. The other thing we're doing particularly with India is using that as the base.

We connected our operations and our purchasing groups to increase our capability there globally. We've done that in terms of our structure reporting up even through me. And we're using the India facility and that technical expertise that we have invested in there to help us further our global purchasing footprint, particularly in Asia.

So that's where we would expect some gains to be made and it looks promising, but we'll wait until we've got -- the fish landed in the net before we declare victory there..

Okay. And then just lastly, could we maybe come back to the initial -- the kind of 4% to 6% revenue guidance range versus the initial forecast? And obviously the components have shifted intuitively, given presumably higher weighting towards North America and less international.

But maybe just a little bit more granularity in terms of that 30% growth in the North America energy piece. I mean if you don't want to give us a point estimate, can you just give us kind us some help? You mentioned that you had some of the inquiry levels that came through in the second quarter.

So maybe just how we should be thinking about that business for the second half?.

Sure. To Larry's earlier comments, as we think about it and the ramp rate significant, that has certainly been in the first half, as we think about the second half and reaching some I would say interim point of critical mass in that market.

When you compare first half to second half, we certainly expect second half to be up sequentially, I would say, in a meaningful way. Having said that, we're still well below when you look at it on a full-year basis, still well below the 2011, 2012 peak levels.

But our forecast again is based on feedback from end users and multiple source, if you will, there. To Larry's earlier comments, as well, I think the volatility speaks for itself. So we're not going to get over our skis on this at this point.

I think there's a number of things that we need to see developed in the second half and continuing to see support at the molecule level.

And frankly, I think some of the things that are going on outside North America as well, when you think about the global view and what's happening there, whether we're going to see more equipment being sourced out of North America for Asia and some other areas remains to be seen. So it's something we're paying a fair bit of attention to.

The service, the aftermarket piece of that though is relevant when you look at the development of Q2. Year-over-year it's up about $9 million, which is obviously significant, or $3 million sequentially. So again, as we think of that piece's leading indicator, it certainly is a healthy increase.

Having said that, to Larry's earlier comments, we would expect more or less second half to be relatively consistent with the first half there..

Okay. Well, I'd like to thank those on the call this morning. We appreciate the interest. We'll speak again next quarter. Good day..

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation..