Carl D. Anderson - Meritor, Inc. Jeffrey A. Craig - Meritor, Inc. Kevin Nowlan - Meritor, Inc..

Joseph Spak - RBC Capital Markets LLC Brett D. Hoselton - KeyBanc Capital Markets, Inc. Neil Frohnapple - The Buckingham Research Group, Inc. Ryan Brinkman - JPMorgan Securities LLC.

Good day, ladies and gentlemen, and welcome to the Q4 2017 Meritor, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. As a reminder, today's conference is being recorded. I would now like to turn the call over to Mr.

Carl Anderson, Vice President and Treasurer. Sir, you may begin..

Thank you, Chelsea. Good morning, everyone, and welcome to Meritor's Fourth Quarter and Full Year 2017 Earnings Call. On the call today, we have Jay Craig, CEO and President; and Kevin Nowlan, Senior Vice President and Chief Financial Officer. The slides accompanying today's call are available at meritor.com.

We'll refer to the slides in our discussion this morning. The content of this conference call, which we are recording, is the property of Meritor, Inc. It's protected by U.S. and international copyright law and may not be rebroadcast without the expressed written consent of Meritor.

We considered your continued participation to be your consent to our recording. Our discussion may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Let me now refer you to slide 2 for a more complete disclosure of the risks that could affect our results.

To the extent we refer to any non-GAAP measures in our call, you'll find the reconciliation to GAAP in the slides on our website. Now, I'll turn the call over to Jay..

to grow revenue by 20% above the market; increase EPS by $1.25 or 80% to $2.84, and achieve a net debt to adjusted EBITDA ratio of less than 1.5 times. As we scorecard ourselves against those targets, here is where we are, keeping in mind that our jump-off point was the end of fiscal year 2015, so we are now halfway through the M2019 cycle.

We have earned more than 6% towards our revenue target of 20% outperformance. And if you look at what we've won in total, we are really more than 14% toward our goal, but still have work to do to get all of those wins fully into the P&L.

We remain confident in reaching 20% outperformance and will provide more visibility on those opportunities in December. In terms of improving profit, we've earned $0.29 toward our objective of increasing EPS by $1.25 on our path towards $2.84.

In addition to our strong performance contributing to this metric, we amended certain retiree medical benefits in the fourth quarter that we expect will reduce this expense by approximately $39 million annually. That should provide a tailwind to our EPS as we look ahead. For capital allocation, our net debt to adjusted EBITDA ratio was 2.7 times.

However, on a pro forma basis, for the Meritor WABCO divestiture, we are at 2.1 times. With two years left in the plan, we believe we are on track to achieve all three objectives. In fiscal year 2017, we took the opportunity to initiate and complete several strategic actions, all of which we believe will contribute to success of M2019.

I'll talk more about those in a few moments. Additional highlights from the year that position us as a market leader include receiving Navistar's Diamond Supplier Award, Ashok Leyland's first ever Gold Delivery Award, and excellent supplier recognition from XCMG and eight quality awards from major customers, six of which were from Daimler.

We also developed electric drive axles and suspensions that we believe will position us as a leader in electric solutions for the commercial vehicle market; launched a new value brand called Mach that features all-makes products engineered to industry standards at affordable prices for our aftermarket customers; established a West Coast aftermarket distribution center in California that will enable us to fulfill aftermarket orders to customers in 24 hours or less; and achieved a safety rate of 0.48 injuries per 200,000 hours worked.

Our target for M2019 is to achieve a rate of less than 0.65, which we beat this year. The safety of Meritor employees are top priority. And even though we believe this incident rate positions us among the best industrial companies in the world, we will continue to work with our employees toward even further improvement.

On slide 5, you'll see eight products we've launched in fiscal 2017. This year's launch cycle included axles for truck and trailers, front and rear, medium and heavy, and on and off highway vehicles. We believe this aggressive launch cycle ensures we can offer our customers the broadest and deepest range of products in the industry.

Meritor's robust product portfolio is a key element to winning incremental business and growing our top line at the pace we have committed to under M2019. Slide 6 represents some of the new business we were awarded in fiscal year 2017 with major truck, trailer, bus and coach, specialty and defense customers in several major regions of the world.

We earned new axle business with Volvo Thailand and Volvo Eicher, as well as a new contract from Tata's Ultra trucks. We're now supplying JAC Motors and Qingling with our dual light family of products in China.

We developed a tandem axle with hub reduction for a major customer outside of North America that will be used on a new series of construction vehicles.

We have a new axle contract with Kenworth for our heavy haul customer in the Middle East and with Navistar Defense for its MaxxPro recovery vehicle program, as well as a contract to supply transfer cases for the new GM and Navistar Class 4 and 5 medium-duty truck. We also have standard axle position with Heil Trailer on its chemical trailer line.

As important as these new business wins are to us, we recognize the importance of maintaining and growing the relationships we have with our long-term strategic customers, all of whom we continue to collaborate with on new opportunities for today and tomorrow.

In that regard, we're excited to announce that we have extended our long-term European axle contract with Volvo through 2024. During the term of this contract, we will perform a technical upgrade to our axle offering that incorporates higher efficiency and higher gross combination weight capabilities.

On slide 7, you'll see more detail on our acquisition of the product portfolio and related technologies Fabco Holdings and its subsidiaries.

With this suite of products, particularly the addition of transfer cases and gearboxes, we now have an expanded portfolio of complementary products for medium, heavy and extra-heavy vehicles for on and off-highway, construction, defense, rail, and other industrial applications for both OE and aftermarket customers.

This transaction allows us to offer global customers a wider breadth of capabilities and will help us diversify and expand into the rail and oil and gas industries. We expect this transaction to generate approximately $50 million of incremental revenue in fiscal year 2019. Let's turn to slide 8.

Also in fiscal year 2017, we closed the sale of our interest in the Meritor WABCO joint venture for a total purchase price of $250 million, and also received the final partner earnings distribution of $8 million just prior to closing. We believe this transaction allows us to further sharpen our focus on the strategic priorities of M2019 and beyond.

We will also remain the exclusive distributor of certain WABCO aftermarket products in the United States and Canada and a distributor in Mexico through an aftermarket distribution agreement.

Either party can terminate these distribution arrangements at certain points during the first three and a half years at an exercise price between $225 million and $265 million based on the earnings of the business. In the end, we believe this was a good transaction for the company and our shareholders.

Now, I'll turn the call over to Kevin for more detail on our financials..

Thanks, Jay, and good morning. On today's call, I'll review our full-year financial results and then I'll provide you with an initial look at our 2018 guidance. Overall, we had an excellent year of financial performance as we expanded adjusted EPS by 15%, drove revenue growth of approximately 5% and generated $81 million of free cash flow.

We also significantly improved the balance sheet as we reduced our total debt and retirement liabilities by more than $600 million. As a result, we now have positive book equity for the first time since 2008.

With this strong performance and improved capital structure, we are well-positioned to deliver on M2019 financial commitments and to continue driving value for our shareholders. Let's turn to slide 9 where you'll see our full-year financial results compared to the prior year.

Sales were up $148 million from last year on higher production in Europe, China and South America. But more importantly, we increased revenue from new business wins coming online. These factors more than offset the 6% decline in Class A truck production in North America during the fiscal year.

We expanded gross margin by 90 basis points as we converted on incremental revenue while also continuing to achieve strong material, labor, and burden performance that more than offset the impact of higher net steel costs.

You can really see the impact of this performance in the line item Volume, Mix, Performance & Other on the right side of the chart, as we have $59 million of higher adjusted EBITDA on $139 million of higher revenue.

Embedded within this line item is approximately $26 million of steel headwind so you can get an idea of the strength of our conversion and operating performance. As we have discussed during the last couple of quarters, we did have a $16 million unfavorable year-over-year impact from two discrete items.

First, we had a one-time unfavorable $10 million settlement with our joint venture partner in Mexico in 2017 related to disputes between the parties. And in 2016, we had a favorable supplier litigation settlement of $6 million that did not repeat. Next, you'll see the foreign exchange with a slight tailwind to revenue in 2017.

The EBITDA impact from foreign exchange was a $12 million benefit on a year-over-year basis. This favorability was primarily driven by hedged mark-to-market gains this year and a corresponding hedge loss a year ago. All of these transactions were executed as part of our hedging program to mitigate the risk from currently fluctuations.

Moving down the (15:18), you can see that SG&A, excluding the various litigation settlements, increased by $35 million this year. Due to strong financial performance in 2017, our variable compensation expense was $21 million higher than in 2016. In addition, we have $15 million in higher asbestos expense this year.

This was driven by the favorable insurance settlements related to asbestos we executed in 2016 which did not repeat. These were the two main drivers of our higher SG&A expense in 2017. As we look ahead to 2018, we do expect to see more normalized incentive compensation accruals.

However, we are starting to strategically add head count and other investment in support of our M2019 revenue growth initiatives. So, while you will see a step-down in SG&A for incentive compensation, it will be partially offset by this increased investment going forward.

These items provide the walk from an adjusted EBITDA of $327 million a year ago to $347 million this year, which resulted in our reported adjusted EBITDA margin of 10.4%. This also allowed us to drive adjusted income from continuing operations of $170 million or $1.88 per share, which is an increase of $0.24 per share from last year.

We did see a relatively low effective tax rate of 5% in 2017 due to several favorable tax items in the year. That rate is lower than what you should expect going forward. Slide 10 details full-year sales and adjusted EBITDA for our reporting segments.

In our Commercial Truck & Industrial segment, sales for full-year 2017 were just over $2.6 billion, up 7% from last year, driven by nearly $100 million in new business wins that were in the P&L as well as stronger end markets. Europe and Brazil truck production levels are up approximately 5% and 20%, respectively.

While in China, our revenue increased by more than $40 million due to a stronger off-highway market. In India, we expanded revenue by $30 million even as truck production was down 9% in the fiscal year. During the year, we benefited from one of our largest customers gaining market share, and we increased our share with that customer as well.

Finally, in North America, Class A truck production declined 6%, but our revenue was roughly flat due to the impact of our new business wins. Segment-adjusted EBITDA was $244 million, up $36 million or 17% from last year. Segment-adjusted EBITDA margin for Commercial Truck & Industrial came in at 9.3%, an increase of 80 basis points from a year ago.

The margin improvement was driven by conversion on the higher revenue and continued material, labor and burden performance, partially offset by higher net steel costs and higher variable compensation accruals. In our Aftermarket & Trailer segment, sales were $853 million, down $7 million from last year.

Our aftermarket business was up slightly in 2017. However, this was more than offset by lower production in the trailer market. Segment adjusted EBITDA was $106 million, down $9 million compared to last year. Segment adjusted EBITDA margin decreased to 12.4% compared to 13.4% in the same period a year ago.

The decrease in margin was driven by the $6 million prior-year supplier litigation recovery I referenced earlier, as well as higher variable compensation accruals. Turning to slide 11, I wanted to provide more detail on a couple of important items we announced in the fourth quarter.

In September, we received a favorable court ruling that dissolved the 2006 injunction previously barring the company from making healthcare benefit changes to certain retirees. As a result, we announced our intention to modify these benefits, which was the primary contributor to the $343 million reduction in our OPEB liability at year-end.

We expect our retiree medical expense to improve by $39 million going forward from $24 million of expense to $15 million of income in 2018. Additionally, we expect to see a $13 million reduction in corresponding cash payments in 2018. On the right side of the chart, I wanted to highlight the convertible debt transactions we executed.

We funded the repurchase of $236 million of convertible notes with a new $325 million convertible note issuance and with $93 million of cash on hand. The new security was issued with a 3.25% coupon and a 60% conversion premium, which pegged the conversion price at nearly $40 per share.

As a result of these transactions, we were able to lower interest expense by $3 million annually, eliminate more than 5 million shares of dilution at today's stock price, and extend the debt maturity profile such that there are no significant bond maturities until 2024. Next, I'll review our fiscal year 2018 market outlook on slide 12.

Building on strong fourth quarter production, combined with an improving freight environment, we are planning for higher Class A truck volumes in 2018. As you know, October can be a bellwether month for truck orders, and this year, the orders came in at more than 36,000 trucks.

As a result, we are projecting North America Class A production of 260,000 to 280,000 units in 2018, up 10% to 18% from 2017 levels. We also believe the medium-duty market will be between 230,000 to 250,000 units in 2018, similar to last year.

As we look overseas, Europe should be relatively stable in 2018 as economic indicators continue to show solid freight fundamentals. Looking to Asia, we expect the market in China to be roughly flat on a year-over-year basis and, in India, we are seeing some moderate growth in our end markets.

Finally, our outlook for Brazil is that the market will be up slightly. Market optimism appears to be returning and GDP is expected to be positive for the second year in a row. Based on these demand assumptions, you can see how that translates to our fiscal year 2018 outlook, which is summarized on slide 13.

We expect sales to be between $3.6 billion and $3.7 billion, up 8% to 11% compared to 2017. Higher class A truck volumes in North America coupled with new business wins are expected to drive a meaningful step up in revenue for us. We are forecasting that our adjusted EBITDA margin will expand again in 2018 to a range of 10.8% to 11.0%.

There are several components that drive our margin expectations for next year. On the positive side, we expect margin expansion related to the $39 million improvement in retiree medical expense and from normal conversion on higher revenue.

Partially offsetting this are the $27 million of lower earnings resulting from the sale of our interest in the former Meritor WABCO joint venture as well as the planned increase in SG&A and engineering investment to support our M2019 revenue growth initiatives.

We also expect our adjusted diluted earnings per share to increase to a range of $2.20 to $2.40, a meaningful step-up from last year. Included in this guidance is our expectation that we will return to a more normalized effective adjusted tax rate of approximately 15%.

In part, that's because we are expecting to generate cash tax expense in certain European jurisdictions where we have now fully utilized our net operating loss carry-forwards. And finally, we anticipate generating free cash flow of approximately $90 million to $100 million.

This is even after investing another $100 million of CapEx in 2018 in support of our M2019 growth and operational performance initiatives and investing in working capital to support the $250 million to $350 million in revenue growth.

Overall, you can see that our 2018 guidance suggests continued improvement in the financial performance of the company as we drive toward achievement of our M2019 targets. Now, I'll turn the call back over to Jay for closing remarks..

Thanks, Kevin. Let's go to slide 14. On December 7, we'll host an Analyst Day event in New York. At that time, we look forward to a more detailed discussions with you about M2019 and our financial outlook. We hope you will be able to join us.

Also, before I close, I want to take the opportunity to acknowledge the excellent work by our global leadership team and the efforts of every Meritor employee over the past year.

The alignment and dedication of our 8,200 employees is reflected in the results we shared with you today and the noteworthy transformation of the company over the past several years. So to our employees and to the investment community, Run With The Bull. Now, we'll take your questions..

And our first question comes from the line of Joseph Spak with RBC Capital Markets. Your line is open..

Thanks. Good morning, everyone..

Good morning..

Good morning..

The first question, I guess, is just on the Aftermarket & Trailer business, which kind of gets a little bit less attention.

I know you had a tough comp in the quarter with the insurance settlement last year, but I guess what I want to better understand is sort of really for the year, what happens? I think early in the year, you were talking about sort of a 14% target. It obviously came in below.

And I guess, more importantly, how we should think about that segment heading into 2018..

Yes. Good question, Joe. I mean, we continue to expect that this is a business that will operate north of 14% margin. So that's the start point. Obviously, we came in at only 12.4% for the year.

Now, one of the big headwinds that the aftermarket business face is because of the total company performance for the year, we outperformed relative to our incentive compensation plans.

So there is about $7 million, $8 million of allocation of variable compensation accrual to that segment which drove the margin down about a point versus what we would normally expect. So as we jump into 2018, we would expect with normalized incentive compensation accruals to already be a point higher than that.

The rest of the gap between call it low to mid-13%s and getting to north of 14% where we expect really comes from revenue growth. As part of M2019, we're driving new business wins into that business, as well as many other businesses, and we contribute at a pretty healthy rate in aftermarket because it is a scale business.

So we would expect the revenue growth that we're anticipating to ultimately drive us to 14% or more where we expect the business to operate..

Okay. And sort of moving on to the overall 2018 outlook and guidance, appreciate some of the color on sort of the puts and takes there. I was sort of trying to follow along. So I guess this is somewhat back of the envelope.

But it would seem like the SG&A step-up and increase you talked about for investments would either have to be fairly hefty, or should the incremental margin on the volume, the assumption there is sort of a little bit below sort of what you realized over the past couple of quarters.

So I'm assuming it's some conservatism built into the latter or is there something that we're not thinking about on the incremental margin, maybe perhaps steel costs, et cetera..

Yeah. It's a couple of things and you've touched on them, and I'll just give a little bit more color. But, keep in mind, we are talking about expanding our margins, again, 40 to 60 basis points year-over-year. So it's a pretty healthy expansion.

The two things I would guide you on is, one, as you think about revenue growth, we typically convert 15% to 20% and we've been at the higher end of that range really for the last year.

As the markets step up in a pretty aggressive way, particularly here in North America, you can have some inefficiencies in the system that really drives us to the lower end of that range. So as you're modeling the walk from 17% to 18% on revenue, I would model us closer to the 15% than the 20%. So that's point number one.

And then second, as it relates to some of these investments, some comes through the SG&A line in the forms of additional head count and other costs we're adding; some comes through the gross margin line in the form of engineering-related expense, both of which are intended to support revenue growth M2019 and beyond M2019.

And so those are really the key offsets to may be some of the other math that you're doing that still get us though to 50 basis points plus of margin expansion..

And the higher steel costs or other commodity costs, have you embedded in that incremental margin range you've talked about?.

Yeah. I mean, ultimately, steel is a little bit of tailwind as we go from 2017 to 2018 as long as steel costs moderate. The last quarter, they were up modestly, but as long as they hold flat where they are, steel should be a year-over-year tailwind, but we'll see how steel costs play out for the year..

Okay. Thanks a lot, guys..

Thank you. And our next question comes from the line of Brett Hoselton with KeyBanc. Your line is open..

Good morning..

Good morning, Brett..

Good morning, Brett..

Let's see, a couple of quick questions here. First of all, again, back of the envelope math, if I look at your 2019 target, it seems like you're going to be able to hit your net leverage ratio of 1.5 just by expanding your EBITDA or increasing your EBITDA and maybe a minimal amount of debt paydown.

So it seems like a large portion of your free cash flow goes towards share repurchase, am I incorrect in that?.

I think a couple of things. As we sit here today, we think we are on the path to hitting 1.5 times net debt-to-EBITDA with the combination of EBITDA growing as well as our cash flow expectations because that impacts net debt.

But where we sit today in terms of driving toward our solid to strong BB credit metrics, we don't think there's any additional gross debt paydown that we need to do to accomplish those objectives, which means any of the incremental capital that we're generating over the next couple of years we can use to support our M2019 growth initiatives or longer-term growth initiatives as well as opportunistically buying back shares in the market.

And so we'll deploy capital in both ways as we look ahead..

As I'm looking at kind of like the little subtitle here, return 25% of free cash flow to shareholders, what would the other 75% in your mind go towards?.

Well, the other 75%, that's a measure over the four-year period from 2016 to 2019 and some of it goes for debt reduction that's allowed us to hit our net debt-to-EBITDA target and some of it will continue to be invested in the business to support our new business win objectives.

As we look at that 25%, I mean, keep in mind, we deployed a lot of capital – a lot of cash, $93 million in September to execute convertible security repurchases which eliminated 5 million shares of dilution in the marketplace. So it was actually a contributing factor toward helping us allocate capital toward share buybacks effectively..

Okay. I'll swing back around and get back in the queue. Thank you..

Thank you. And our next question comes from the line of Neil Frohnapple with Buckingham Research. Your line is open..

Hey, guys. Congrats on a great quarter..

Thank you, Neil..

Maybe a follow-up on the margin question.

Is the outlook for the lower variable comp in FY 2018 going to fully offset the higher SG&A cost as part of the investment for M2019?.

Not completely in the SG&A line. I think the benefit we'll see from the reduced variable compensation accruals will largely offset the increased investment which will come through SG&A and the ER&D or engineering line. But it's not a complete offset, but it's a substantial offset..

Okay.

And then could you provide more granularity on the sales bridge from FY 2017 to FY 2018 cause for (31:50) $300 million increase at the midpoint? Are you able to provide the revenue contribution to the FY 2018 revenue guidance from new business wins that will be realized this year, I guess, both carryover from M2016 and then for the wins from M2019? And then I think you guys called out certainly the higher North America Class 8 production.

That probably adds over $100 million at the midpoint. But if you could just talk through any other revenue tailwinds and headwinds that underpin the sales guidance, that would be helpful..

Sure. I mean, I think if you look at it, there's really two big drivers.

The first is you touched on the NA truck, the Class 8 truck market, which, if you do the simple math that we guide you to, every 5,000 Class 8 trucks being worth $20 million, that suggests in our guidance a step-up in revenue of between $90 million and $170 million given the range that we're giving of 260,000 to 280,000 Class 8 truck point.

As it relates to new business wins, including the Fabco revenue coming into the P&L this year and including M2016 carryover that's coming into the P&L still, we expect that to be north of $160 million going from 2017 to 2018. And then we get a little bit of a tailwind from our India guidance as well, probably another $20 million there.

So when you add it all up, that gets you to our range of $3.6 billion to $3.7 billion..

Okay. That's helpful. And then just a quick follow-up on that, Kevin.

What's the Fabco implied in that $160 million that you called out?.

It's roughly about $35 million..

Okay. Great. Thanks. I'll pass it on..

Thank you. And your last question comes from the line of Ryan Brinkman with JPMorgan. Your line is open..

Great. Thanks for taking my question. At the North America Commercial Vehicle Show during the quarter, we heard a lot about electrification of commercial vehicles from both suppliers and OEMs. I'm curious if you could highlight what you think is the content per vehicle opportunity for Meritor from this trend..

Sure. Yeah. Thanks, Ryan. This is Jay. I think you had the opportunity to visit our booth and see our product offerings there. We displayed three specific offerings. The most significant of which was the e-axle.

So we believe if the e-axle is adopted, obviously, the overall content would increase because we're replacing with that single product, the internal combustion engine, the transmission and the existing drivetrain. So we think there are opportunities for additional content.

But our main focus is to at this point make certain that we're as represented in the future in the marketplace as we are today in drivetrain.

So we'll be talking a lot more about that at the Analyst Day including our different strategies around with it, whichever vehicle architecture is the one that ends up dominating different vehicles certainly in the future..

Okay, great. Thanks. I appreciate that. I think later today there's going to be or should be a Tesla Semi truck unveil.

I'm just curious how you see – which vehicles do you think are you targeting that there is the most opportunity? Is it more of that kind of long-haul Class 8 stuff or Class 8 or is it – which types of electric vehicles do you think that there's the most opportunity for you?.

Well, I think it would be interesting to see Tesla's unveil today. We're excited for them. And, certainly, that segment as I understand what they're addressing which is the day cab segment primarily on their initial launch, has a lot of opportunity. I think when you can push vehicles upwards to 300-mile range, you can do a lot of day cab delivery.

Again, our thesis is the most aggressive markets near term to grow will be the medium-duty delivery, the transit bus, and refuse sectors. And so when you look at our different product offerings, those are the markets they're being initially directed toward..

Okay. Very helpful. Thanks for the color, and congrats on the quarter..

Thank you..

Thanks..

Thank you. And this concludes today's question-and-answer session. I would now like to turn the call back to Carl Anderson for any closing remarks..

Thank you, Chelsea. This does conclude Meritor's fourth quarter earnings call. If you do have any follow-up questions, please feel free to reach out to me directly. Thank you..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day..