Good day and thank you for standing by and welcome to the Q2 2021 Meritor Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded.

[Operator Instructions] I would now like to hand the conference over to Todd Chirillo, the Senior Director of Investor Relations. Thank you. Please, go ahead, sir. .

Thank you, Felicia. Good morning, everyone, and welcome to Meritor's second quarter fiscal year 2021 earnings call. On the call today we have Chris Villavarayan, CEO and President; and Carl Anderson, 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're recording, is the property of Meritor Inc. It's protected by U.S. and international copyright law and may not be rebroadcast without the express 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 two 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 Chris. .

Thanks, Todd. Good morning, everyone, and thank you for joining us today. Let's turn to slide three. We had strong results this quarter, with $983 million in sales and adjusted EBITDA margin of 11.3%. Total company sales were up 13% year-over-year, as truck demand increased in all our global markets.

Free cash flow performance was excellent this quarter, coming in at $47 million. This was one of our highest second quarter cash flows since we began the implants in 2013. Once again, the Meritor team demonstrated its ability to successfully respond to markets.

Even with the sharp increase in volumes and supply chain challenges, we maintain excellent delivery and quality performance for our customers, while converting increased sales to profits at expected levels.

Looking at the full fiscal year, we're holding our sales, margin and cash flow guidance, despite indications that we will have one of the largest unfavorable steel impacts we have seen, in addition to higher expense in electric powertrain development, as we ramp up production capabilities to meet the increasing demand.

Carl will provide more detail, but our ability to offset these headwinds reflects the consistent strong execution you expect from us. We have a brand-new electrification program to announce this quarter, in addition to an exciting new opportunity to accelerate development of our 17Xe electric powertrain in Europe.

And in our core business, we have recently finalized long-term agreements with two global OE customers. Please move to slide four. In the second quarter, we extended our agreement with Navistar through 2026. We are pleased to continue our long-standing relationship with Navistar, as it becomes part of the Traton family.

This agreement extends our current relationship, while providing opportunity for future growth in our major product categories of axles, brakes and drivelines. We also completed a new agreement with IVECO in Europe through 2024.

This includes the supply of single reduction axles and strengthens our successful business relationship between our companies. It also provides the opportunity for future growth on other product lines. With Navistar and IVECO complete, most of our long-term agreements with major customers have been renewed well past the 2022 time frame.

Moving to electrification on slide 5. We are pleased to announce a new collaboration with Hexagon Purus Systems, a global leader in zero emission e-mobility. Hexagon will integrate Meritor's 14Xe powertrain into its Class 6, Class 7 box trucks and Class 8 6x4 vehicles starting 2021.

Customers, including PACCAR, AutoCar, line electric Volta trucks and Hexagon have chosen Meritor's 14Xe integrated electric powertrain. We believe this is market validation of its industry-leading performance.

In early 2020, we announced an agreement with PACCAR to be the initial launch partner and supplier for the integration of the fully functional battery electric systems on the Kenworth T680 and Peterbilt 579 and 520 electric vehicles. We have begun prototype production and PACCAR is performing validation testing on its test tracks.

It's very exciting for us to see these fully electric vehicles being assembled. Soon these and many others with Meritor's preferred electric powertrain solutions will be fully operational on roads and highways. Please take a minute to view a video of this truck in motion on meritor.com.

This footage was shot last week, at our Escondido California facility. With market adoption growing for our 14Xe, we're now shifting the focus to the development of the 17Xe platform in Europe. Last month, we learnt we were a grant recipient of the advanced propulsion center in the United Kingdom.

This grant will partially fund the development of Meritor 17Xe. After a comprehensive months-long nomination and consideration process, we were thrilled to be selected along with our consortium partners Danfoss Editron and Electra Commercial Vehicles.

This grant totaling almost £16 million will rapidly accelerate development of this product, that is designed for multiple vehicle platforms and extend our ability to offer Meritor's e-powertrain solutions for the European market. We believe demand for this product will grow because of the EU 2025 CO2 reduction targets.

Stricter targets will start applying in 2030 and by 2040 all new trucks sold in Europe will need to be fossil-free to reach carbon neutrality by 2050. The 17Xe is another significant step towards completing our electric powertrain portfolio. Carl, will now provide details on our financial results..

Thanks, Chris, and good morning. On today's call, I will review our second quarter financial results and provide an update to our fiscal year 2021 outlook. As Chris mentioned at the beginning of the call, we delivered another quarter of strong financial performance. Adjusted EBITDA margin was 11.3%, and we generated $47 million of free cash flow.

Now, let's review our financial results compared to the prior year on slide 6. Before I continue, I want to highlight a revision we are making to our presentation of two non-GAAP measures, adjusted income from continuing operations and adjusted diluted earnings per share.

To better align with SEC guidance, we will no longer include in non-GAAP measures the adjustment for non-cash tax expense related to the use of deferred tax assets in jurisdictions with net operating loss carryforwards or tax credits.

It is important to note, this is a change to our reporting metrics only as the underlying availability and benefit of tax attributes to offset future taxable income has not changed. We expect to maintain an effective cash tax rate of approximately 15% through the M2022 planning cycle.

In the appendix, we have also updated prior periods to reflect this change providing for consistent comparatives. Now let's review the details of our financial results. Beginning with the total company, revenue came in at $983 million, up $112 million from the same period last year.

As economies rebounded globally, we saw increased truck production in all of our markets. Net income from continuing operations was $63 million, compared to $240 million last year. As a reminder, prior year results include $203 million of after-tax income related to the termination of the distribution arrangement we had with WABCO.

This was partially offset by the recognition of value-added tax credits in our wholly owned Brazilian entity of $22 million or $15 million net of tax during the second quarter of fiscal year 2021.

Adjusted EBITDA for the second quarter was $111 million, which translates to an adjusted EBITDA margin of 11.3%, a decrease of 100 basis points from the prior year. Adjusted EBITDA this quarter excludes the $22 million Brazil value-added tax credit I previously mentioned.

The decrease in margin was primarily driven by an approximately $20 million impact from incentive compensation cost compared to the prior period. Keep in mind, last year we significantly reduced our incentive compensation accrual at the onset of the pandemic. Additionally, we experienced higher freight costs as compared to a year ago.

This higher expense was offset by cost reduction actions executed in the second half of last year. Overall, we were pleased with our margin performance, especially given some of these cost headwinds. Adjusted diluted earnings per share was $0.68, up $0.04 from last year. And free cash flow for the quarter was very strong at $47 million.

Last year we generated $292 million of free cash flow, which included $265 million related to our distribution agreement termination. If you adjust for the one-time impact from last year, free cash flow improved $20 million year-over-year.

Based on our market outlook and expectations on cash flow generation going forward, we are in a position to return to a more normalized level of cash on our balance sheet. We therefore are announcing the redemption of the remaining 6.25% notes due in 2024.

The $175 million principal balance will be redeemed at the call price of just over 101%, utilizing available cash on hand, which was $321 million at the end of the second quarter.

Our objective of maintaining BB credit metrics through market cycles was reinforced this past year, as we were able to successfully manage through the onset of the pandemic. Upon completion of the debt repurchase, our gross debt balances will be similar to where we were pre-COVID.

We were also on track for net leverage to be approximately two times this year and plan for a further step down in 2022. Now let's look at our segment results compared to the same period last year. Sales in commercial truck increased by 23%, driven by higher global truck production in all markets.

Segment adjusted EBITDA for commercial truck was $73 million, up $15 million from last year. Segment adjusted EBITDA margin increased to 9.4%, an increase of 20 basis points over the prior year.

The increase in segment adjusted EBITDA and EBITDA margin was driven primarily by conversion on higher revenue and by cost reductions actions executed last year. This was partially offset by higher incentive compensation and freight costs.

Aftermarket and industrial sales were $247 million in the second quarter, down $30 million compared to the prior year. The decrease in sales was primarily driven by the termination of our distribution arrangement, which occurred in the second quarter of fiscal year 2020.

Segment adjusted EBITDA was down $12 million compared to the second quarter of 2020 and segment adjusted EBITDA margin decreased to 13.8%. The decreases were driven primarily by the impact from the termination of our distribution arrangement and increased incentive compensation costs, partially offset by cost reduction actions.

Before I review our current global market outlook on slide 7, I want to provide an update on supply chain constraints in the markets we are closely monitoring. Global supply chains, primarily for semiconductors have become constrained during this global production upturn.

This has affected many global manufacturing industries including commercial trucks. We are seeing some impact to production schedules as a result. In India, the current wave of the pandemic is having a significant impact on the country, which could affect the ability of our OE customers and suppliers to manufacture in the short run.

Demand however, remains high in all of our markets. In particular, order activity in the North America Class 8 market continues to be robust averaging over 40,000 units per month in our fiscal second quarter and cancellation rates remain very low.

Overall, as we assess all of the pluses and minuses, we are keeping our global production outlook unchanged as we balance strong global demand with potential supply chain constraints. Let's turn to slide 8 for an update to our fiscal year 2021 outlook.

Consistent with our market assumptions, we are holding forecasted sales to be in the range of $3.65 billion to $3.8 billion unchanged from our prior forecast. We are also maintaining our adjusted EBITDA margin guidance steady at an expected range of 10.6% to 10.8%. We are however seeing steel costs continue to increase.

Since September hot-rolled coil prices have increased more than 130% and scrap prices are up nearly 100%. The price movement in steel has been the most severe and rapid increase we have seen over the past 10 years.

As a result, we now anticipate a full year headwind of $25 million to $30 million in higher steel costs up $10 million from our prior review. Most of this impact will be felt in our third fiscal quarter as prices begin to reset with our steel suppliers.

While this is a significant headwind in 2021, we do a pass-through mechanism in place with our customers, which are typically on a three- to six-month lag. We expect to see most of this recovery beginning in early fiscal year in 2022.

Additionally, we are increasing our electrification spend between $5 million to $10 million from our prior guidance as we continue to respond to this growing opportunity. While we are experiencing these higher costs, we expect to be able to offset most of these increases through continued operational performance.

Our purchasing team has done an excellent job in driving material performance savings and we continue to see the benefits from cost reduction actions executed last year. Moving to adjusted diluted earnings per share, our outlook for 2021 is now in the range of $2.15 to $2.30.

This reflects the impact from the adjustment for non-cash taxes as well as the lower interest expense expected from the bond redemption. Our effective cash tax rate of approximately 15% in fiscal 2021 remains unchanged. And finally, we are maintaining our expectation to generate between $110 million to $125 million of free cash flow.

Overall, the team is doing a fantastic job, managing through the challenges of the strong global rebound and deliver a solid glide path to M2022. Now I will turn the call back over to Chris. .

Thanks, Carl. Let's turn to slide 9. While it is difficult to schedule events with certainty, we're planning to hold our Analyst Day in person this year in New York. More details will be provided in the coming months. At that time we will present M2025.

We will move of course -- we will of course closely monitor the situation as we move closer to this date to ensure we can meet safely. Before we close I would like to express our concern for the serious situation occurring in India as the pandemic worsens.

Our team in the region has taken actions to help employees and the community through care centers, vaccination and mobile testing facilities and we plan to do more. Our thoughts are with our colleagues and their families during this crisis.

Again, I want to thank you for joining us today to review Meritor's second quarter results and welcome any questions you may have at this time. .

[Operator Instructions] And your first question comes from the line of James Picariello of KeyBanc. .

Hey, good morning..

Good morning, James..

Just within the company's reiterated guide for the year, you're now anticipating what was I think referred to as record commodity inflation in the back half, right not surprisingly, but can you help quantify what the net headwind exposure is relative to what will likely flow through within your recovery mechanism just to get a sense of that net exposure?.

Sure. James, it's Carl. As it relates to steel prices, which is the really primary driver for us we do expect it to be year-over-year about $25 million to $30 million headwind in fiscal 2021.

So if you think about the recovery mechanisms as that begins to kind of flow through that will come through really beginning in fiscal -- the first part of fiscal 2022. And so of that we would expect to be recovering around probably $20 million of that number as we go forward. .

Okay. No that's really helpful. Just from an industry standpoint focusing on the North American market for a second, I mean again from an industry standpoint we're trying to get near record order levels. This year the industry backlogs are also going to be at or close to all-time highs.

Are you seeing anything unique in terms of builds build commitments build slot commitments for next year at this point? It just seems as that's where we're going to be especially given the temporary chip shortage impacts which I think are also proving to be more muted. Just seems like we're on track for a really, really strong volumes next year. .

For sure, James. I'll take that. So when you think about it it's beyond the last three months. If you look at it it's the last six months. Order intake has come in at 40 or above 40. And to your point, backlogs are passing I think, I believe 300,000.

And for our fiscal year right now the midpoint with the recent change is -- it's 285000 for the fiscal between ACT and FTR. And if you look at the midpoint for next year for the heavy market, it's at about 340. So to your point great highs and you got to believe the Texas storms resolved, as well as the fire in Japan.

So the chip shortage will get resolved here shortly or will improve shortly. We do believe there is impact through the next couple of quarters, but it eventually should improve. So again we believe there's a strong 2022 ahead of us as well. .

Got it. If I could just squeeze one more in.

Within the aftermarket and industrial segment this quarter's -- the second quarter's margins was there anything within that related to the timing of price increases or excess of premium freight? Just any color on that segment's margins?.

Yes, James, it was really just driven by a couple of factors. One was, we did see some higher freight costs in the second quarter, as well as a little bit higher cost from steel that affected the aftermarket business..

Thanks..

Thank you..

Our next question comes from the line of Joseph Spak of RBC Capital Markets..

Thank you. Appreciate it. So I think just to maybe sort of to get a little better sense for some of the costs you talked about Carl in the back half, I think, if we look at the guidance it still implies on a year-over-year basis about 20% incrementals.

But I think that seems to be maybe some of the base period in the map, because is it fair to assume that sequentially we should see maybe decrementals a little bit higher than normal given some of the headwinds and then as you can start to get some of those recovery mechanisms back next year that reverts?.

I think that's the right way to think about it Joe. If you look at the six months EBITDA margin performance to-date, we're right around 11.4%. So if you think what our guide is of 10.6% to 10.8% that does imply the second half margins will be about 10% on roughly the same type of revenue..

Right. Right. Okay. Thank you for that. Just a bigger picture question on electrification. I know you have to --you're up in the spend again here. In the past when you've talked about that it's really sort of been to support programs that you think are sooner rather than later.

So maybe if you could just sort of confirm again if that increase of 5% to 10% is for that.

And then somewhat related on electrification, can you talk at all about your ability to attach other Meritor products like maybe disc brakes, for instance, like when you get eAxle limbs like is there a pretty high attach rate for Meritor when you're able to do that?.

Absolutely Joe, but I'll start with the first question. First, I think, glad to see the backlog continuing to grow. As you remember, we talked about having this $500 million target for electrification as our revenue pipeline. We accomplished $400 million of that with the -- at the last quarter.

And so with this announcement with Hexagon, we've taken a chunk of that. So we continue to see the growth. And to put it in perspective of spend, if you go back to 2019, we spent about $12 million. Last year we spent $21 million, and this year we're moving it up to $35 million to $40 million.

So we're almost doubling it per year, and it's primarily because of the wins and it's essentially application and testing of our products as it wins with more customers.

To your second question, the ability to attach components, absolutely, we do see a path with brakes -- as primarily with brakes with many of the customers as an opportunity to grow business as well. .

But when you up your electrification backlog, I mean, those associated products I am assuming are not in that.

So is it fair to assume the other side of your backlog is being benefited too by the electrification wins?.

It is on, let's call it, everybody that is, let's call it, new entrants coming into the market. So when you think about the new entrants, we have a significant share of the existing traditional business.

So it is on the new business, but you also have to take into account when you think about electrification always remember it's five times and up to five times content on a 14Xe, for example. So, we're already seeing that growth as well..

Okay. Carl maybe just a quick one on -- thanks for the color on the tax rate and sort of the change in guidance. I think you used to sort of point to mid-teens with the way you sort of adjusted.

So, should we model something more like 20% in the outer years now given the change?.

Well, I think it's -- Joe to that point, it's 15% definitely through 2022. I think once you start getting past 2022 you got to 2023 and 2024; it could begin to moderately step up. So, you're probably not too far off with that assumption..

Okay. Thanks very much..

Thank you..

Your next question comes from the line of Ryan Brinkman of JPMorgan. .

Hi, good morning. This is Ben Fung form JPMorgan for Ryan. I just have two questions.

The first one is what is your view on the impact of higher labor cost to margin and production start to come back? And on the same note, how are you seeing freight cost progressing through the rest of the year? I know that someone in the aftermarket last week said something about the freight cost could be two or three times higher than they're seeing right now.

So, how much impact to margin do you expect this headwind? And what are some factors that can be used to offset the impact? Thank you..

Absolutely. So, let me start with the first question specific to labor. It's a red hot market out there as you could see with the first question. There's significant drive and demand for the product. And I think it's running right through the economy GDPB being strong and consumer spending.

So, in essence, we were able to drive that -- some of that recovery is specific to that with some of our customers. However, on top of that, it's really about operational performance. It's driving incremental operational performance whether it's labor and burden in how we look at our lines or whether it's how we look at material opportunities.

So, that's how we drive that savings to offset labor. Specific to freight, we're seeing about three times more freight in terms of cost to your point whether it's on ocean or internal as well. And for those elements what we are again doing is trying to offset a lot of that with -- sorry with material performance and operational performance.

But on top of that we also look at working with our customers as well..

And I'm sorry to ask.

So, this is pretty cost and everything already factored in the guidance, right?.

Yes, it is. Yes. And to add to what Chris said, as we look at just overall freight costs in our first quarter, we did experience probably higher premium costs associated with the rapid increase in production that we saw in the first quarter.

But the -- what we're seeing is kind of just the basic run rate with cost today is all factored into our guidance..

Thank you. Very helpful. And my second question is on the RV business. So, the RV demand has been very strong in the last few months and just this morning an RV dealer up their adjusted EBITDA guidance materially.

Can you talk about the opportunity for growth in this area of the business? And I think last quarter you mentioned something about independent suspension. With wheels and motors for RVs? And if you can please just give any update on that? Thank you..

Absolutely. So, the industrial specialty and off-highway markets are incredibly important for us. This is why we did the AxleTech and Fabco acquisitions two years ago. And so we are seeing the fruits of those acquisitions as we think through 2022 and our -- as we look at our revenue pipeline growth.

When we think about the core business and as we have talked about exceeding our revenue targets for 2022, a lot of it is coming in our industrial Defense & Specialty business and a lot of it is driven by this. So we are seeing that growth. Again last quarter we talked about developing an independent suspension for this market.

And it is going into production this year and it will be in run-rate next year. And then second is we're also developing a similar system on the electric side. So we're looking at an electric platform that requires to accomplish us the same thing as well for the RV space..

Thank you very much for taking my question..

The next question comes from the line of Bruce Chan of Stifel..

Hey good morning, this is Matt Milask on for Bruce Chan..

Good morning Matt..

Morning. With regards to higher freight costs, you mentioned one of the mitigating things that you're doing is working with customers.

Any additional color we can get around there and how those conversations might be going?.

Sure. I think when we -- at this point, we are working with customers that we have agreements in certain regions. And as you could imagine, they are hard agreements and they take a while to work through. And it's a discussion that we are working through and we are seeing the benefits in some areas..

Thanks a lot..

Thank you..

And your next question comes from the line of Itay Michaeli of Citi..

Good morning everybody. Just two quick ones for me. First just a little bit of housekeeping on CapEx. I mean, it looks like it's still running maybe below the full year. And I think the original plan for the cumulative CapEx through 2022 was about $475 million.

Just curious whether you're seeing efficiency there if that's just some timing?.

Good morning Itay. It's more timing. For the first six months, we had about $25 million of CapEx. We are planning for about $70 million of CapEx in the last six months of the year. So part of it was production came back pretty quickly as you recall in our first fiscal quarter.

And I think some of the programs we are just beginning to ramp back up here this quarter as well as in the fourth quarter for us..

Great. That's helpful color. And just -- I think you addressed it to the prior questions, but just as we think about that bridge from the second half margins to the 2022 target, I think you mentioned some of the recoveries on steel.

But can you just maybe walk us through some of the bigger puts and takes in terms of what -- at least some of the headwinds that you're facing today that are contractually going to reverse next year particularly on the other steel side?.

Yeah. Itay, the biggest thing we're seeing when you really boil it down is really on steel. So as I referenced that $25 million to $30 million headwind is really a second-half story for us.

So while freight costs what we've talked about are -- have increased and are elevated from what they have been historically our material performance and some of our operational performance items have been able to offset that. So the true story is steel.

And if you were to simply adjust for this deal of $25 million to $30 million; our margins would be very similar to what they are here in the first and second quarter..

Got it. Perfect. That’s real helpful. Thanks..

Thank you..

And there are no further questions at this time. And I'll turn the call back over to Todd Chirillo..

Great. Thank you, and thank you everyone for joining our call today. If you have any questions please feel free to reach out to me directly. Thank you and have a great day..

And this concludes today's conference call. Thank you for participating. You may now disconnect..