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

Gene Vladimirov - UBS Securities LLC Faheem F. Sabeiha - Longbow Research LLC Neil Frohnapple - The Buckingham Research Group, Inc. George Clark - RBC Capital Markets LLC Michael James Baudendistel - Stifel, Nicolaus & Co., Inc. Alexander Eugene Potter - Piper Jaffray & Co..

Good day, ladies and gentlemen, and welcome to the Q3 2018 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 follow at that time. I would now like to turn the call over to Carl Anderson, Group Vice President-Finance.

Please go ahead..

Thank you, Eylea. Good morning, everyone, and welcome to Meritor's third quarter 2018 earnings call. On the call today, we have Jay Craig, CEO and President; and Kevin Nowlan, Senior Vice President and President-Trailer and Components, 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're recording, is a 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 consider 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..

Thanks Carl. Good morning, everyone. Let's turn to slide 3 for the financial highlights of the quarter. Year-over-year, revenue increased 23% to more than $1.1 billion driven by higher production in all of our major markets, new business wins, and market share increases.

In fact, we believe our market share in rear axles during the past two quarters in North America is the highest in our history. In addition, we expanded adjusted EBITDA margin by 80 basis points to 12% which is also among the best on record for Meritor, and we generated $102 million in free cash flow in the quarter.

We are raising our full-year guidance across the board driven by our excellent performance year-to-date, higher volumes around the world, and sustain strong conversion. Kevin will walk you through the detail later in the call.

With the updated outlook for fiscal 2018, we're excited to tell you that we are on track to achieve two of our three M2019 targets, a full year earlier than planned. These are net debt to adjusted EBITDA and adjusted diluted EPS.

As you know, the financial metrics we established for M2019 were aggressive targets, so achieving them a year early is a significant accomplishment. Remember, our EPS target of $2.84 was an 80% improvement from our jump-off point in fiscal year 2015.

We are proud of our employees and leadership team around the world for the focus and alignment they've shown. This was demonstrated to a great degree over the past year as we have successfully met our customers' production requirements while maintaining world-class levels of quality and delivery seen by few in the industry.

In the third quarter, our higher absolute earnings and free cash flow generation combined with our balanced approach to capital allocation have enabled us to achieve our net debt to adjusted EBITDA target, and we did that while buying back an additional 1.4 million common shares. Since 2015, we have bought back more than 15 million common shares.

On a go-forward basis through the balance of our M2019 strategy, we expect to continue to deploy capital in support of both strategic growth initiatives, including M&A and opportunistic share buybacks. Let's now look at slide 4 for a regional update.

While North America is certainly our largest market, we want to keep you updated on the meaningful growth we're seeing in other areas of the world as the leading provider of drivetrain and breaking components to the commercial vehicle industry.

In the past quarters, we've given you highlights on South America and China; today, we wanted to give you a more detailed look at our growing India business.

First of all, you'll note that we've raised our production outlook again for India by approximately 30% year-over-year, and now expect to be in the range of 410,000 to 420,000 medium and heavy-duty units. If you've been following the economy in India, you know that GDP is strong and expected to get stronger next year.

Increased infrastructure investment is having a favorable impact on the commercial vehicle industry.

Meritorious volumes of on- and off-highway axles as well as military axles and brakes are significantly higher this year due to the surge in the industry and our expansion of business with major players and including Ashok Leyland, Tata, Volvo Eicher and Mahindra in the heavy-duty and medium-duty segments for a variety of applications.

As we look ahead to next year, certain policy actions are also expected to continue to drive strong demand in India.

These actions include mandatory scrapping of trucks that are more than 20-years-old which should trigger replacement purchases, in addition to the upcoming Euro 6 emission standard which we expect will create a pre-buy ahead of the regulation which takes effect in April of 2020.

Through our Automotive Axles Limited joint venture with the Kalyani Group, we are investing approximately $20 million in the Mysore facility to add capacity for axle and brake production as we expect sustained growth for the foreseeable future.

This joint venture is nearing its 40th year and continues to be an excellent partnership for us as we grow in this region. If you turn to slide 5, I'll highlight some of the great new business wins. First, we have a couple of exciting new awards in Europe.

We've talked previously about our hub reduction platform for which we have a common design and standard production system around the globe. This has enabled us to successfully localize the product in every region of the world. We will be manufacturing our MT-32-610 hub reduction axle for construction and mining trucks for a major customer in Europe.

And in Turkey, we have two new programs with BMC for construction and linehaul applications. Meritor will supply BMC with hub reduction axles as well as our 18X. In defense, we have a major content on the new heavy dump truck program for Mack Defense.

For this we will supply rear beam and front steer axles as well as drivelines and transfer cases amounting to tens of thousands of dollars of content per vehicle. The initial contract award is for approximately 700 trucks. In addition to this business, we continue to opportunistically pursue and win other military programs.

We anticipate these will provide an incremental revenue stream in the coming years. As we look at our position in commercial vehicle electrification, we recently earned new business with Ashok Leyland in India in addition to a program with a major OE that will use Meritor's e-axles in 14 of its electric trucks.

Two of those vehicles will be completely equipped with content from TransPower through our strategic relationship. We are also working with Thomas Built Bus, a subsidiary of Daimler Trucks North America on the development of a battery electric powertrain solution for its school bus platform.

Our first prototype has been on the road in California since April. This is the first commercial vehicle with a fully-functional Meritor 14X e-axle, coupled with TransPower technology. In June, we announced the appointment of John Bennett to a new position at Meritor as Vice President and Chief Technology Officer.

We believe this will be a crucial role as we grow in the commercial vehicle electric space, whether through the evolution of existing products like our 14X axle for which we are redesigning gears and downsizing brakes, or through the development of all new products like the e-axle.

We are taking the appropriate actions to remain a market leader and we will greatly benefit from John's expertise. One additional opportunity I wanted to tell you about is a significant award for our components business. This is a five-year contract (00:10:07) and one of the largest wins we've received since officially launching this business.

Over the life of the contract, we expected to produce more than 3 million pieces and we expect production to start in early 2020. Now, let's turn to side 6. We wanted to acknowledge our global team today for recognition by several customers for outstanding performance in quality, delivery, customer service, field support, and new product development.

These awards are always important to us but earning them in this timeframe is particularly meaningful considering the high demand requirements we've been successfully managing for many quarters, as I said earlier in the call. Now, I'll turn the call over to Kevin for more detail on the financials and then we'll open it up for your questions..

Thanks, Jay, and good morning. On today's call, I'll review our third quarter financial results and our updated outlook for the remainder of the year. As you heard from Jay, we had a very strong quarter of financial performance.

We achieved an adjusted EBITDA margin of 12%, saw revenue increase to over $1.1 billion, and generated over $100 million of free cash flow. Let's walk through the details by first turning to slide 7 where you'll see our third quarter financial results compared to the prior year.

Sales were almost $1.13 billion in the quarter driven by a combination of higher production in all major markets and continuing revenue outperformance. In North America, Class 8 truck production was 79,000, up 13,000 trucks from a year ago.

We expect production levels will step up further in the fourth quarter as our order board remains at high levels. Sales in Europe were also up in our third quarter driven by increased volumes. As Jay has highlighted over the last several quarters, we are seeing year-over-year growth in our other international markets.

In fact, we saw about $40 million of the sales growth in the quarter come from our businesses in Brazil, China, and India.

In addition to strong end markets, revenue outperformance achieved primarily through market share increases and new business wins continues to supplement our sales growth and accounted for approximately $50 million of the increase in sales from last year.

Driven primarily by higher revenue, we generated adjusted EBITDA of $135 million and increased adjusted EBITDA margin by 80 basis points compared to last year.

As you can see from the chart on the right side of the slide, we converted on incremental revenue at just over 15% on an all-in basis, consistent with our expectations for this market environment. As we've discussed before, we have two items that will continue to impact year-over-year performance through the balance of this fiscal year.

These include $8 million in lower equity earnings and affiliates resulting from the sale of our interest in the Meritor WABCO JV at the end of last year and $10 million in lower OPEB expense resulting from the modifications we made to our U.S. retiree healthcare benefits in September.

Noticeably absent in our causal is the impact of tariffs and escalating steel costs on our financials. Let me speak briefly about each of these. In the case of steel tariffs implemented to-date, we import very little raw steel into the U.S. from abroad.

As a result, the impact of steel tariffs on us has been de minimis thus far in 2018, but of course the landscape is changing frequently so we'll continue to monitor the situation including the potential late-August imposition of the new Section 301 tariffs on a broader set of imports from China.

In this environment of strong market demand and escalating trade rhetoric, we have seen domestic steel prices increasing fairly significantly. In fact, the Hot-Rolled Coil Index has increased 44% since last year, inclusive of an 18% increase sequentially. The result has been an escalation in our steel costs.

However this escalation has been mitigated by our recovery mechanisms which have been offsetting prior increases in steel indices thereby negating the year-over-year impact on our financials. In fact, on a year-over-year basis steel was a slight positive for us in Q3.

Moving to the left side of the chart, you can see that we expanded gross margin by 30 basis points to 15.7% driven by conversion on incremental revenue and lower pension and retiree medical expense. Adjusted income from continuing operations was $80 million, or $0.89 of adjusted diluted earnings per share, a 39% increase over last year.

And finally, we generated $102 million of free cash flow this quarter. In addition to higher operating earnings, we also benefited from lower retiree medical benefit payments and reduced cash interest due to the deleveraging actions we have executed over the last 12 months.

Let's move to slide 8 which details our third quarter sales and EBITDA for both of our reporting segments. In our Commercial Truck & Trailer segment, sales increased by 24% to $904 million.

While the increase in revenue was driven primarily by higher market production in North America, we also saw increases in every other major market in which we operate. In addition, we saw continued benefits from new business wins and market share increases. Segment adjusted EBITDA was $103 million, up $32 million from last year.

Segment adjusted EBITDA margin for Commercial Truck & Trailer came in at 11.4%, a 160-basis-point increase over last year.

The increases in both EBITDA and EBITDA margin were driven primarily by conversion on higher revenue and the favorable impact of changes to retiree medical benefits, partially offset by lower affiliate earnings from the joint venture divestiture in the previous year.

In our Aftermarket & Industrial segment, sales were $273 million, up 15% from last year. The increase was driven by higher volumes across our North America Aftermarket business and higher sales in our Industrial business which included revenue from the business we acquired in the fourth quarter of fiscal year 2017.

Segment adjusted EBITDA was $35 million, up $5 million compared to last year. Segment adjusted EBITDA margin was 12.8% compared to 12.7% last year.

The increases in both EBITDA and EBITDA margin were driven primarily by the favorable impact of changes to retiree medical benefits and conversion on higher sales, partially offset by higher material and freight costs. Next, I'll review our fiscal year 2018 global market outlook on slide 9.

The North America truck market is showing no signs of slowing down in the near-term with Class 8 net orders over 40,000 units for four of the last six months and a backlog-to-build ratio of approximately eight months.

We are maintaining our outlook for Class 8 and Class 5-7 production at 300,000 units to 310,000 units and 240,000 units to 250000 units, respectively.

Trailer volumes have continued to show considerable strength during this fiscal year driven by more drop and hook activity due to driver shortages and the ELD implementation, as well as more frequent lighter loads resulting from increased e-commerce activity. We are increasing our estimate by 20,000 to 310,000 to 320,000 units in 2018.

Europe remains at strong production levels and South America continues to recover. We've increased our outlook for Europe by 5,000 units and maintained our previous outlook for South America. As we've discussed on this call, the India market continues to expand. We have increased our 2018 outlook there by 12% to 410,000 to 420,000.

This would be the first year that this market has exceeded 400,000 trucks. And finally, our revenue expectation for our business in China has increased by 8% to approximately $210 million to $220 million. Overall, end markets across the globe along with revenue outperformance are driving the strong top line growth this year.

And importantly, we are successfully converting on this revenue opportunity. Based on these market assumptions, you can see on slide 10 that we are again raising our 2018 guidance. We are now forecasting revenue to be approximately $4.1 billion on the high end of our prior guidance.

We're now expecting an adjusted EBITDA margin of approximately 11.3%, a 10-basis-point increase from our prior outlook. We are also raising our adjusted diluted earnings per share from continuing operations guidance to a new range of $2.90 to $3 per share.

Just to reiterate what Jay said earlier, we're excited that we are on track to achieve two of our three M2019 targets one year early inclusive of our adjusted EPS target. And finally based on our higher earnings expectations, we are increasing our free cash flow guidance to be in a range of $135 million to $145 million.

This cash flow guidance includes an approximately $60 million investment in working capital this year to support revenue growth. We would expect any incremental investment in working capital to subside as revenue level stabilize.

As a result, we see the $135 million to $145 million in free cash flow in FY 2018 as the starting point from which we expect future growth in cash flow looking to FY 2019 and beyond. We are very pleased with our performance so far in 2018 as we continue to execute on our M2019 commitments. Now, we'll take your questions..

Our first question is from Colin Langan with UBS. Your line is open..

Hey. Good morning, guys. Gene Vladimirov on for Colin.

Would you be able to give us some color on your Aftermarket margin outlook for the rest of the year? And then when you think about the segment, what sort of timeframe should we be thinking about in terms of getting to that 14% target margin?.

With respect to Aftermarket & Industrial, we haven't simply revised the segments here. Last quarter, we haven't given a new guidance outlook in terms of what we expect the long-term run rate for that business to be. I think we're pretty pleased with the performance on a year-over-year basis.

We saw margins up a little bit on a year-over-year basis, and we're continuing to progress as we look to Q4.

We have been taking actions to make sure we improve the margin of the underlying Aftermarket business which is the majority of that business, inclusive of executing some pricing actions here on July 1st which should flow through in our fourth quarter results..

Got it. Helpful.

And then with North America truck kind of at peak levels, just wondering how you're thinking about growth opportunities for next year?.

I think you should keep in mind of the $800 million of revenue growth year-over-year that about 25% of that is new business wins.

So it's not just market growth and as I spoke to you on the call today, we continue to have meaningful new business wins in all our focused areas of growth, be it defense, off-highway, components, internationally, and Europe. A lot of our new product introductions in China are starting to take hold in the mid-market segment.

So, we still feel we have a lot of headroom for growth in the areas we targeted as part of the M2019 program..

Got it. Okay, great. Thank you. Good luck for the rest of the year..

Thank you..

Thank you..

Our next question is from Faheem Sabeiha with Longbow Research. Your line is now open..

Hi. Good morning, guys, and congrats on a good quarter.

Just wondering if you can provide a little more color around the increased market share in the quarter, were they share gains in the heavy-duty and medium-duty markets, or do they have anything to do with the industry supply constraints that allowed Meritor to achieve higher share?.

We certainly have been successful in meeting the demands of the market. We think we're – as I mentioned, we're among the best in the industry at that. And if you go back to some comments I've made in previous quarters, that's really no accident. We've proactively built inventory banks in critical component areas.

We've invested in our manufacturing capabilities to respond to what we expected to be increased market share from our new business wins. So, we have reached what we believe is the highest market penetration we've ever had in North America, and are very pleased with that performance so far..

Okay. And then regarding your components business, it felt like the focus with components was to drive a higher off-highway business, but you guys won business on a light-vehicle platform.

So is the light-vehicle market the direction for this business? I mean, could we see more wins in the space, and do you have to make additional investments in the business to meet light-vehicle volume levels?.

No, the primary focus is not on the light-vehicle side, but as you know, the crossover between medium-duty trucks and then into some of what are classified as light-duty vehicles, there is some crossover on those components.

So, we did target this particular market where we achieved a significant win this quarter when we set the strategy for the business, and it was a very intentional product development and focused sales effort on this particular segment..

Okay. Thank you. I'll pass it along..

Our next question is from Neil Frohnapple with Buckingham Research. Your line is now open..

Hi. Good morning. Congrats on a great quarter. I guess starting on the revenue guidance, so you called off NAFTA commercial vehicle production schedules implies a sequential increase from the FY third quarter, and I realize there are some summer shutdowns in Europe, U.S.

dollar strengthened a bit, but curious on any other drivers and why the implied sales outlook for the fourth quarter is $125 million lower than Q3. And I can appreciate, you're being conservative in light of some of the supplier constraints and trade noise, but I want to make sure I'm not missing something there..

Yeah. Neil, this is Kevin. A few things. One is, as you alluded to we typically have the seasonal shutdowns in Europe which is probably the biggest driver of the revenue step-down we expect sequentially in Q4.

But keep in mind that some of our other businesses typically hit seasonal peaks coming out of the third fiscal quarter, that includes Aftermarket, China, India, Trailer which all typically take a step down in Q4.

And then on top of that, we're going to see currency become a little bit of a headwind sequentially as we look at what's happened with the euro heading into the fourth quarter. So, all those things are contributors to the step down in revenue in Q4..

Okay. And could you just talk more about the industry supply constraints that occurred this past quarter; any notable impact to results you would call out? And then, more importantly, how Meritor is managing any headwinds. I'm just curious if these are improving..

We have not had supply constraints that resulted in us missing critical deliveries to our customers, so we have not incurred those.

I wouldn't say that is without some Herculean efforts and at times some typical actions you see in an upturn like this expedited freight and things of that nature, but so far we have been able to deliver on our commitments to our customers even at these very high levels..

Okay, great. And then if I could just sneak one more in. So the new business wins, Jay, continue to come through for you. You called out several in the presentation.

So is the $260 million of incremental revenue from new business wins that's expected to hit the P&L in FY 2019 on a year-over-year basis, is that still a good number to think about irrespective of volume changes and the underlying end markets for next year?.

We're not ready to update our guidance for 2019 as of yet, but we're still confident in the level of new business wins that we're driving and you can see and as Jay mentioned a good chunk, 25% or so, of our revenue increases this year are related to the revenue outperformance and we would expect that to continue the trajectory that we're on heading into 2019.

But we'll provide more of an update on that when we give our 2019 outlook in November..

Okay, great. Thanks. I'll pass it on..

Our next question is from Joseph Spak with RBC Capital Markets. Your line is now open..

Hey, guys. This is George Clark on for Joe. Just a quick question on your incremental margin assumption in the fourth quarter, it looks like it's around 12%, but you guys have been executing around 15% over the past three quarters.

So, can you just give us some color on what the drivers are for that, kind of, lower outlook?.

Yeah. I mean the biggest driver of that is really that we have incremental steel headwinds as we go from Q3 to Q4.

We've seen, as I mentioned in my remarks, certain steel indices even going up 18% sequentially from Q3 to Q4 and that's going to continue to hit us or start to hit us from a cost perspective in Q4 and we won't see the recovery benefit of that until we get into 2019.

So, when you adjust for that call it about $4 million of headwind in Q4 sequentially then that puts us into our typical conversion on downside revenue driven by the revenue step-down we just talked about in response to Neil's question with Europe, China, India, and some of the other markets stepping down..

Okay.

And then kind of off of that steel comment, into 2019 as you guys start to see the recoveries from this year, could that be a little bit of a tailwind from a margin standpoint, if steel prices kind of start to level off a little bit?.

I think it's hard to say at this point, and I don't think we're prepared to give a 2019 outlook yet. There's been so much volatility in steel prices and with the trade rhetoric that I think we need to see where things are going to settle down over the next few months before we can really give an outlook there.

We do, of course, have those recovery mechanisms in place that tend to be on about a six-month lag. So, if steel prices were to level off at a particular level or steel indices were to level off, we would start to see the recovery benefit on that about six months later, but we'll give more fulsome guidance in the November call..

Okay. Great. Thanks, guys. Great quarter..

Thank you..

Our next question is from Mike Baudendistel with Stifel. Your line is now open..

Thank you.

Just wanted to ask you, I mean, so much of the investor discussion has been around the Class 8 market peaking, and just wanted to get your perspective now that so much of the revenue development opportunities have been in international markets, and off-highway markets and medium-duty and defense, et cetera, what portion of your revenue now is tied to the Class 8 tractor market that is so highly volatile?.

Well, we haven't disclosed that in the past, but I can tell you as we look forward to our future business plans, we think we can sustain a reasonable step-down in Class 8 production while holding revenue relatively flat because of all the significant new business wins that we've achieved, as you noted, outside the North American Class 8 market.

And I think this quarter was just a great example of all those significant wins that are really around our diversified business..

Got it. That's good.

Just also want to ask you, just on the adjusted EBITDA margins now at record levels, over 12%, can you just walk us through a little bit about how much of that was a function of the higher volumes this year and operating leverage and how much of that is going to be sustainable if we were to go to, say, a mid-cycle type level where North American production is 220,000 to 240,000 instead of 310,000?.

Yeah. I mean, as we look at jumping from last year's 10.4% margin for the full year to this year's 11.3% margin, we've obviously seen a significant uptick in revenue, about $750 million in our guidance on a year-over-year basis, and we've been converting on that at around 15%.

And so, that's – there are some other puts and takes in there, but that by and large has been the driver to-date. But remember we were jumping off at 10.4% last year and expecting to continue to improve even with revenues not being as strong coming into the year.

So, we continue to expect as we look ahead to be able to deliver material labor and burden performance in environments where the markets becomes – returns to more normalized levels.

I think when we talk about our outlook for 2019 as well as our strategy for what's next at our December Analyst Day which we're targeting you'll hear us talk about what our expectations are for those margins over the cycle, but I think your expectation should be that this is not – 11.3% for 2018 is not the peak for our business..

Got it. And then I think I missed earlier, the recovery on your steel prices, how long is the lag or when do you actually recover it from the higher prices, is it in a couple quarters or....

It's normally a couple of quarters, six to nine months lag from the time the indices start impacting us from a cost perspective. They tend to lag then in terms of customer recoveries on go-forward pricing about six to nine months..

Got it. That's all I had. Congrats on meeting that multi-year EPS target..

Thank you..

Thank you..

Our next question is from Alex Potter with Piper Jaffray. Your line is now open..

Yeah. Hi, guys. You mentioned the euro there briefly.

Was wondering if you could comment, I guess, also on forex volatility elsewhere, obviously you've got some pretty severe currency movements in South America, the RMB has been moving in China; just wondering if you can update us generally on the extent to which that'll end up having any translational/transactional impacts on your earnings and revenue..

I mean, they had some impact in the quarter, for instance, if I look year-over-year, we did see a little bit of favorability, single-digit millions of dollars from a revenue perspective related to the euro primarily.

But as we look ahead as I mentioned we see what the euro has done here the last month or so, it has strengthened which will create a little bit of a headwind sequentially. But all in, the biggest driver of the movements that we're seeing in revenue right now are by and far end markets as well as our revenue outperformance.

And at the end of the day, currencies aren't that significant an impact as we look at earnings both Q3 and Q4..

Okay. I noticed you took up the China revenue guidance again really nicely.

Can you comment on how much of that was off-highway versus maybe some on-highway revenues starting to creep in?.

I think it's a mix of both. As I mentioned on the call, we are seeing penetration of the new products that we've developed and introduced into the Chinese on-highway market really take hold. And as we spoke to you previously, we also export to other areas in Asia.

The products that we produce in China because of the quality levels that we produce them out we're able to export them into other Asian markets..

Okay. Great.

And then last one, you mentioned expedited freight supply chain constraints, doesn't sound like that's impacting the OE side of the business at all, but perhaps you're seeing that maybe more so in the Aftermarket segment, was I reading that correctly?.

I think that is correct. And as Kevin mentioned in response to a previous question, we have executed some price increases here in Aftermarket to compensate for the increased freight costs we're seeing, the increased material costs.

We do not have, for the most part, automatic pass-through mechanisms that we have on the OE side in our Aftermarket business, but we have pushed through these pricing increases recently which is part of our expectation why we continue to expect to see improvement in the margin of the Aftermarket business as the year goes on..

And I'm showing no further questions. I would now like to turn the call back over to Carl Anderson for any further remarks..

Thank you. This does conclude Meritor's Third Quarter Conference Call, and we thank you for your continued participation. If you 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. You may now disconnect. Everyone, have a great day..