Meritor, Inc.
Q4 2017 Earnings Call Transcript

Published: 15 Nov 2017

[Operator:]

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.

[Carl D. Anderson:]

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.

[Jeffrey A. Craig:]

Thanks, Carl, and good morning, everyone. Let's turn to slide 3 for a look at the quarter. Kevin will take you through the full-year analysis later in the presentation. Our revenue in the quarter was $922 million, up 27% from the same period last year. This increase was driven by higher production in all regions and the traction we're getting with new business wins. Adjusted EBITDA for the quarter was $98 million compared to $74 million in the same period last year. Margin in the fourth quarter was $10.6%, an increase of 40 basis points. While we've had good margin performance in past quarters, our margin this quarter reflects the benefit of the higher volumes and our continued excellent operational performance. The majority of the margin improvement was driven by conversion in our Commercial Truck & Industrial business where our margin expanded 280 basis points to 10%. We converted around 18% on incremental sales of $187 million in this business, with tremendous delivery and quality performance across the board. You may remember that we also demonstrated near-perfect execution in the strong markets of 2015. This speaks to the sustained level of operational excellence that has now become a competitive differentiator for Meritor. Adjusted income from continuing operations in the quarter was $56 million for the total company or $0.62 of adjusted diluted earnings per share, nearly double from the same period last year. Across the company, we have put a tremendous effort into ensuring that we deliver sustained improvement in our financial results, and we take pride in the fact that we are consistently meeting or exceeding our commitments to shareholders. We intend to continue that trend. Let's go to slide 4 for a brief update on progress towards our M2019 objectives. We will provide more detail at our upcoming analyst event in New York in December. As you know, our three M2019 financial targets are

[Kevin Nowlan:]

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

[Jeffrey A. Craig:]

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.

[Operator:]

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

[Joseph Spak:]

Thanks. Good morning, everyone.

[Kevin Nowlan:]

Good morning.

[Jeffrey A. Craig:]

Good morning.

[Joseph Spak:]

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.

[Kevin Nowlan:]

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.

[Joseph Spak:]

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.

[Kevin Nowlan:]

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.

[Joseph Spak:]

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

[Kevin Nowlan:]

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.

[Joseph Spak:]

Okay. Thanks a lot, guys.

[Operator:]

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

[Brett D. Hoselton:]

Good morning.

[Kevin Nowlan:]

Good morning, Brett.

[Jeffrey A. Craig:]

Good morning, Brett.

[Brett D. Hoselton:]

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?

[Kevin Nowlan:]

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.

[Brett D. Hoselton:]

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?

[Kevin Nowlan:]

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.

[Brett D. Hoselton:]

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

[Operator:]

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

[Neil Frohnapple:]

Hey, guys. Congrats on a great quarter.

[Kevin Nowlan:]

Thank you, Neil.

[Neil Frohnapple:]

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?

[Kevin Nowlan:]

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.

[Neil Frohnapple:]

Okay. And then could you provide more granularity on the sales bridge from FY 2017 to FY 2018 cause for (31

[Kevin Nowlan:]

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.

[Neil Frohnapple:]

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?

[Kevin Nowlan:]

It's roughly about $35 million.

[Neil Frohnapple:]

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

[Operator:]

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

[Ryan Brinkman:]

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.

[Jeffrey A. Craig:]

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.

[Ryan Brinkman:]

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?

[Jeffrey A. Craig:]

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.

[Ryan Brinkman:]

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

[Jeffrey A. Craig:]

Thank you.

[Kevin Nowlan:]

Thanks.

[Operator:]

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.

[Carl D. Anderson:]

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.

[Operator:]

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.