Navistar International Corporation
Q4 2018 Earnings Call Transcript

Published: 19 Dec 2018

[Operator:]

Good day, ladies and gentlemen and welcome to the Navistar’s Fourth Quarter 2018 Earnings Results 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. [Operator Instructions] And as a reminder, today’s conference call is being recorded. I would now like to turn the conference over to Marty Ketelaar, Vice President, Investor Relations. Please go ahead.

[Marty Ketelaar:]

Thanks, Candice. Good morning, everyone and thank you for joining us for Navistar’s fourth quarter and year end 2018 conference call. Today, we will discuss the financial performance of Navistar International Corporation for the fiscal period ended October 31, 2018. With me today are Troy Clarke, our Chairman, President and Chief Executive Officer and Walter Borst, our Executive Vice President and Chief Financial Officer. After concluding our prepared remarks, we will take questions from participants. In addition to Troy and Walter, joining us today for the Q&A session are Persio Lisboa, Executive Vice President and Chief Operating Officer; Michael Cancelliere, President of Truck and Parts; Phil Christman, President of Operations. Before we begin, I would like to cover a few items. A copy of this morning’s press release and the presentation slides has been posted to the Investor Relations page of our website for reference. The non-GAAP financial measures discussed in this call are reconciled to the U.S. GAAP equivalent and can be found in the press release that we issued this morning as well as in the appendix of the presentation slide deck. Today’s presentation includes some forward-looking statements about our expectations for future performance and the company expressly disclaims any obligation to update these statements. Actual results could differ materially from those suggested by our comments made here. For additional information concerning factors that could cause actual results to differ materially from those included in today’s presentation, please refer to our most recent SEC filings. We would also refer you to the Safe Harbor statement and other cautionary notes disclaimer presented in today’s material for more information on the subject. With that, I will turn the call over to Troy Clarke for opening comments. Troy?

[Troy Clarke:]

Hey, thanks Marty and good morning, everyone. I will provide a brief overview of the quarter and the full year and Walter will walk you through the financials and our 2019 guidance and then we will take your questions. Q4 was a great end to a very good year. Thanks to the Navistar team and our dealer partners for their hard work and contributions. During the quarter, charge-outs increased by 45%, we also grew market share in every vehicle segment both sequentially and year-over-year. We paid off our October convertible notes with cash on hand and we concluded 2018 with a strong cash balance, which will help us address the April 2019 convertible maturities as well and thanks to the steps taken earlier in the year, no other debt maturities are scheduled before 2025. For the full year, there was a significant improvement on nearly every key metric. All four segments, truck, parts, global and financial, posted higher revenue for the year, with also charge-outs adjusted EBITDA and net income. Positive free cash flow was achieved on a full year basis for the first time since 2011. During the year, we also significantly reduced our pension and OPEB liabilities, warranty liability balance and gross used truck inventories. There is strong momentum on market share. Overall, market share in core markets increased for the second consecutive year. Class 8 share for the year was 13.5% compared with 11.8% in 2017 and Navistar was the only truck OEM to grow Class 8 share during 2018. And with strong marketplace preference for the LT series and the A26 engine, our Class 8 heavy market share increased by 2.5 percentage points. We also grew school bus share by 1.3 percentage points. Recently launched truck products, the vocational HV series and medium MV series, help grow backlogs in the medium duty and vocational segments. Entering 2019, these backlogs are 3x as large as the year before. We are moving forward rapidly with our alliance with the Traton Group, saving money for our procurement joint venture and pressing forward in a number of key areas of technology collaboration. These accomplishments position us well to enter 2019 and we anticipate this will be another year of significant progress. From an industry perspective, 2019 is shaping up as another very good year. Freight demand and carrier profit are both strong. Current forecast indicate Class 8 sales remain well above replacement demand through the year. Class 6 and 7 sales will also remain strong due to high replacement demand and growth in key economic sectors. Consumer confidence, the leading indicator of the consumer economy has increased in each of the last few months. The ISM manufacturing index, a leading indicator for the trucking industry still indicates expansion. Construction spending is forecasted to grow by 4.5% next year and small business optimism continues a 2-year shrink of record high. We are calling the market at a range between 395,000 and 425,000 units, Class 6 through 8 plus bus. And during the year, our backlog is 3x higher than it was this time last year. In response to this demand, we have increased production yet again by adding a second shift at the Escobedo plant. In addition to the strong market, we have taken a number of additional steps in building a new Navistar. In November, the new CV series was launched, our reentry into the Class 4 and 5 market. In December, we entered into an arrangement to sell 70% of the defense business to Cerberus Capital Management. This transaction provides Navistar defense with a well-established long-term partner. Also this month, Navistar announced the creation of a new eMobility business unit, led by Gary Horvat, formally the Chief Technology Officer at Proterra. the industry’s leading electricity bus supplier. The investment in this new business unit highlights the importance that Navistar places on emerging technologies and supports future electric power product development. 2018 was special for another reason as well. It’s the year where we no longer preoccupied with the past. We are facing forward, addressing the challenges and opportunities in 2019 and the years to come. And our improvements over the past 5 years have established a strong foundation and we are in a position to generate superior shareholder value. Since shareholder value based on stock price appreciation is a function of future earnings and cash flow growth, no other truck OEM has a better opportunity to grow earnings and cash flow than Navistar. We have upside potential that’s superior to that of the industry based on several factors. First, there is market share. We have only begun to regain the market share that we lost earlier this decade giving us greater upside opportunity. A large part of this opportunity comes from having the newest product lineup in the industry, which is part of an overall solution that emphasizes superior uptime and lower total cost of ownership against the current and prospective customers. Navistar also has unique potential to benefit from parts revenue growth. Our vehicle part will grow with market share gains and as new proprietary power trains developed with the Traton Group provide improved parts opportunities in our trucks and buses. And our alliance with Traton positions Navistar to make more progress in lowering material costs and growing margins. Leveraging the global scale in the procurement joint venture will allow Navistar to offset commodity and supplier cost increases. And there is also upside on pricing. With the legacy issues largely behind us, Navistar can increasingly take price to reflect improved quality in our products and services and higher value to our customers. And as free cash flow is available to pay down the company’s debt load, interest expense will come down and net income will improve substantially. Other OEMs did not have as significant an opportunity for relative improvement. So to recap, while we expect 2019 to be another strong year for Navistar and the industry, it’s important to recognize that Navistar’s investment is much more than a cycle play. As our ongoing improvements indicate, the company also has strong opportunities to benefit by recapturing market share, growing parts revenue improving margins, generating free cash flow and further de-risking and de-levering the balance sheet. We are very pleased with the gains that we have made in 2018. 2019 is shaping up as another very strong year and we have a clear roadmap to sustain future progress. And so with that, let me turn it over to Walter.

[Walter Borst:]

Thank you, Troy and good morning everyone. In 2018, Navistar took another big step forward as it moved from turnaround to growth. During the year, the company grew annual revenue in all segments, increased Class 8 market share 1.7 points, generated significant free cash flow from manufacturing operations and strengthened the balance sheet. In 2019, Navistar looks to build on its successes with additional growth in revenues, market share and margins in its core truck, bus and parts businesses. This morning, I will review the 2018 Q4 results and provide 2019 financial guidance. In the fourth quarter, revenue grew 28% year-over-year to $3.3 billion. The improvement was driven by a 45% increase in core truck and bus charge-outs. Moreover, Class 8 truck volumes grew 60% greater than the industry growth rate of 36%. Gross margin for the quarter was 18.5%. During the quarter, the company continued to face higher freight cost and commodity prices, particularly for steel. The supplier constraints discussed on last quarter’s call have eased, but due to the high order activity, stress in the supply chain remains. For the year, gross margin increased 100 basis points to 18.9%. Warranty expense, including pre-existing, fell to 1.7% of revenue compared to 2.4% last Q4 as the strong quality and reliability of our new products continues to positively impact the financial results. Structural cost, as a percentage of revenue declined to 9.4% this quarter versus 11% last year. Structural costs increased $25 million year-over-year largely from higher investments in the development of next generation power trains and profit sharing accruals. Net income for the quarter grew nearly 40% to $188 million or $1.89 versus $135 million or $1.36 per diluted share last year. Fourth quarter adjusted EBITDA increased 20% to $322 million versus $268 million in 2017. 2018 marks the sixth consecutive year of growth in adjusted EBITDA. On both a dollar and percentage basis, full year adjusted EBITDA was up 42% year-over-year to $826 million or 8.1% of revenue. Turning to the segment results, in the truck segment, charge-offs grew in all core product segments. Sales grew 41% in the quarter to $2.6 billion, reflecting higher volumes, particularly of Class 8 trucks. Truck segment profitability grew 76% to $197 million in the quarter from $112 million a year ago. The increase in profits resulted from growth in truck volumes and cost savings initiatives, including those from the procurement JV with the Traton Group. Navistar defense profitability also grew substantially in the quarter. In addition to strong government sales, defense business realized receipts of $26 million from two requests for equitable adjustment claims on prior government contracts. Headwinds in the quarter for the truck segment included higher commodity and structural cost as well as the impact of supplier constraints. Parts segment quarterly revenues grew to $633 million as double-digit growth in Fleetrite branded components contributed to the continued shift in volumes to more private label sales from proprietary and Blue Diamond parts sales. Segment profits were flat year-over-year as the increase in revenues were offset by higher freight expenses in internal allocation of development, engineering and SG&A costs. In the global operations segment, revenue was $93 million and this segment was profitable in the quarter. Brazilian operations benefited from prior restructuring actions and improved economic conditions. The global operations segment was profitable for the full year for the first time since 2011. The financial services segment grew average portfolio balances due to financing originations with revenues increasing 11% to $70 million. Segment profit was $26 million this quarter comparable to last year as higher revenue was offset by higher borrowing costs driven by larger average loan originations and rising interest rates. Moving to the balance sheet, Navistar ended the quarter with $1.36 billion in manufacturing cash. For the year, Navistar generated positive manufacturing free cash flow of $307 million on strong EBITDA results and net working capital performance from higher truck volumes that more than offset capital expenditures, interest payments, warranty payments and pension and OPEB funding. The company is in a strong cash position to weather its seasonal cash usage in fiscal Q1 and address the $411 million of convertible notes that mature in April 2019. In 2018, the company’s balance sheet improved in several areas. In October, the company repaid its $200 million convertible notes issued in October 2013 with cash on hand, the under-funded status of the pension and OPEB liabilities declined by over $400 million to $2.1 billion due to cash contributions and increase in the discount rate and favorable OPEB claim experience. This decline is on top of a $550 million reduction in 2017. The warranty liability balance fell to $529 million compared to $629 million at the end of 2017, well off its peak of $1.35 billion in 2013. And with inventory, gross used truck inventory fell to $154 million at fiscal year end compared to $206 million in October 2017, representing a third of its peak balance of nearly $450 million back in April of 2016. Earlier this month, the company entered into a definitive agreement with Cerberus Capital Management, under which they will acquire a 70% interest in Navistar defense. Navistar expects to realize approximately $140 million of total value for the defense business, including a 30% equity stake, cash and earn-out proceeds and the transfer of certain liabilities. The deal is expected to close this month subject to regulatory approval. Additionally, the company will benefit from a long-term exclusive supply agreement to build and supply chassis and parts to Navistar defense. The proceeds from the transaction will further bolster Navistar’s balance sheet, while better positioning the defense business for future growth opportunities. Now, let’s turn to 2019. The following guidance includes the fully consolidated financial impact of the Navistar defense business. Once the transaction with Cerberus closes, the company will provide an update to its 2019 expectations, reflecting minority ownership in the defense business going forward. 2019 industry volumes are expected to again be strong largely driven by Class 8 volumes. The company is increasing its expectations of Class 6 through 8 plus bus industry volumes by 10,000 units to 395,000 to 425,000 units. Navistar volumes in 2019 are expected to increase due to share growth and the ramp up of Class 4, 5 volumes. This should enable the company to grow 2019 revenues to $10.75 billion to $11.25 billion. Gross margins are expected to grow next year, despite unfavorable profit mix from higher expected truck sales growth relative to parts sales growth. Improved pricing and material cost savings from the procurement joint venture are expected to more than offset the impact of tariffs in higher commodity prices. All-in, gross margins are expected to increase to between 19% and 19.5% of revenue. In 2019, structural costs, defined as engineering and SG&A expenses, together with certain periodic post-retirement benefit costs that will be recorded in other income and expense going forward, are expected to range between $1.25 billion and $1.3 billion. This is expected to be higher than in 2018 as the company increases funding of ongoing engineering projects as part of the Traton alliance, makes investments to upgrade IT infrastructure to fund sales and service growth initiatives. In total, the company expects 2019 adjusted EBITDA to be $850 million to $900 million. In summary, 2018 was a breakout year for Navistar and marks the end of the company’s turnaround and the beginning of a new phase of long-term growth. In 2019, the company will continue to grow revenue, market share and margins and strengthen its balance sheet. These are very exciting times for Navistar. And as Troy mentioned, the company is well positioned to be the best truck OEM investment opportunity in this sector. With that, I will turn it back to the operator to begin the Q&A.

[Operator:]

Thank you. [Operator Instructions] And our first question comes from David Leiker of Baird. Your line is now open.

[David Leiker:]

Good morning, everyone.

[Troy Clarke:]

Hi, David.

[David Leiker:]

So, I want to talk about high class problem with your balance sheet is, where the cash flow is, you are in a position now to essentially have some excess cash. What are your thoughts on what you do with that and what the structure of the balance sheet looks like going forward?

[Walter Borst:]

Yes. Hey, David, it’s Walter. The first thing that we plan to do is to pay off the convertible notes that come due in April of next year. So that’s a little over $400 million and we are extremely well positioned to take care of that with the year end cash balances that we have. Beyond that, we will continue to invest in the product. We have got a number of growth initiatives, including with the Traton group as we have discussed before and that puts us in a good position to continue to invest in the business as well.

[David Leiker:]

Okay. And then a question on the margins, the truck margin, I guess, how much headwinds are you seeing in there right now operationally and where do you think the upside is of that if you got to a point of just kind of a normal manufacturing environment?

[Walter Borst:]

Yes. Well, we have seen headwinds because the hedges that we had on had rolled off. More recently, we have seen some commodity prices moving in the right direction for us, so that potentially that provides some upside opportunity for us into the future.

[David Leiker:]

Okay. And then just one last, I don’t mind, on the global operations, what’s the strategy for that. I mean, we have spent all the time talking about the truck side of the business in Boston revitalizing that portfolio. We haven’t really spent much time on that part of the business. What are your thoughts there?

[Walter Borst:]

Yes, I will start and maybe some of my other colleagues want to jump in. First of all, we are back to profitability and we expect to grow profitability further in 2019 in our global operations, which are principally our Brazilian operations. Our biggest customer there is MAN and as part of the Traton Group. So we do see additional opportunities there to work together with them going forward.

[David Leiker:]

Okay, thank you.

[Persio Lisboa:]

Well, this is Persio, David. Just complementing what Walter said also there, we had some new products that we are launching in the market that now we will hit now probably 2019. So, we are continuing to invest in the business in a moderate way to make sure that we take advantage of the recovery of the local market in South America.

[Troy Clarke:]

And I think what Persio was really referencing, this is Troy, is that we need to do a better job leveraging some of the technology that we have down there to other Latin American markets to include Mexico, where those products and in those power ranges really give us an opportunity to gain some incremental market share and some additional margins there as well.

[David Leiker:]

Very good. Thank you very much.

[Operator:]

Thank you. And our next question comes from Chirag Patel of Jefferies. Your line is now open.

[Chirag Patel:]

Thanks. Good morning. Just wanted to kind of talk through a little bit about the defense side of the business. I saw in the K that there is about $534 million associated with that in sales for 2018. Just trying to get a sense for how much of the EBITDA contribution was from defense?

[Walter Borst:]

Yes. We haven’t broken that out separately, but the margins for the defense business are slightly higher than the margins that we have in the truck segment overall, so that can probably point you in the right direction. We will provide some additional information on the defense sale once it closes. So I think you will get a better sense of what the revenues and profits for that sector look like in ‘18 at that time.

[Chirag Patel:]

Okay, that’s fair.

[Walter Borst:]

As we look forward to ‘19, we do expect those revenues to decline probably little less than half of the numbers that you mentioned. So less than half of that $534 million as we had a couple of big contracts in 2018 that rolled through our results, in particular, a contract for UAE and another one in Pakistan, that we’ve talked about previously on these calls.

[Chirag Patel:]

Okay. And then, I guess what I’m trying also understand a little bit is, just the margin profile of the truck business ex-defense as we move forward if I kind of strip out a few of the items that were one-time in nature, one being the $70 million in the third quarter that was associated with a benefit there and then the $26 million you just kind of called out here on the defense side that you kind of got there I get to a truck margin for the full year 2018, that’s closer about 4% or so just wanted to get a sense for

[Walter Borst:]

Yes, Truck margins have been increasing here with the stronger volumes and the cost initiatives that we’ve taken, and we expect those to improve again in 2019 we are surely not done on the cost initiative side, in particular, we continue to look at product costs as we look for additional efficiencies in our material costs by working with the procurement joint venture that we have with the Traton Group so we continue to believe that will provide us significant opportunities into the future, that will help us grow our EBITDA margins overall over the next few years.

[Troy Clarke:]

Yes, and this is Troy I mean, maybe taking a maybe how I look at it building on Walter’s comments is, the couple of pieces that impact, I think truck margins going forward first half is the increase in commodity costs but if you think about increased commodity costs, what’s remaining of that should be almost a one-time 2019 type of event and then, we’ll continue to kind of we’ll continue to improve material costs largely through the procurement joint venture that we have with Traton Group and getting to global and getting more global scale and then the third piece of that is then in a couple of years, the advent or the introduction of integrated powertrains to a much higher level than this company has ever experienced before is really pattern of some of our competitors so you see this in a couple of steps I think as we walk out over the next couple of years you will see a steady margin build on trucks largely due to those three things.

[Chirag Patel:]

And the Traton piece was I think we had called it out in 2016 when you guys initially signed up combined was the idea that there’s be 500 million or so in potential savings with $200 million run rate is there any sort of a dollar amount that we can associate with the amount that you’ve already kind of achieved and some sort of level of cadence that we can imply?

[Walter Borst:]

Yes, so those estimates that we have provided back then are still relevant over time, we had indicated 500 million of cumulative savings with a $200 million run rate in the fifth year for the first couple of years, we’re on track or slightly better than what we had anticipated going into the JV a couple of years ago and you see that reflected in our results I also want to come back to a comment you made earlier about the $70 million adjustment that we had in back in Q3 that does run through the truck segment, but it doesn’t run through the gross margins which you tend to see on the face of our presentation deck here.

[Chirag Patel:]

Right so that will just be on the outside expense.

[Walter Borst:]

Other income and expense.

[Chirag Patel:]

Right.

[Walter Borst:]

Yeah.

[Chirag Patel:]

Okay, thank you guys. Appreciate that.

[Operator:]

Thank you. And the next question comes from Ann Duignan of JPMorgan. Your line is now open.

[Abdul Tambal:]

Yes. So, this is Abdul Tambal on behalf of Ann. Just a quick question regarding the Cummins engine, representation from your engines shipped into Q4 I noticed that it’s up around 580 bps year-over-year I’m just wondering if you could kind of explain what drove this increase?

[Troy Clarke:]

Yes. Michael, do you want to go ahead and touch that real quick?

[Michael Cancelliere:]

Yes. So, this is a production mix question and really it’s driven by two things primarily, we had Navistar offering our N9 and N10 at the same period in our vocational products last year, which we don’t have this year that was the primary driver and then also it’s a bit of a customer mix depending upon the customer fleet mix and their engine preference during that period of time, it could swing numbers one way or the other I really wouldn’t overreact to that degree 90 degree.

[Troy Clarke:]

Yes. So just in summary, we had our own 9, 10 engine we have replaced that with the Cummins ISL so it’s 100% Cummins ISL in that particular segment right now and then, Michael’s comment, a handful of these large fleets that we conquested or reconquested, one fleet takes X15s really starts to skew the numbers, just in terms of volume I think kind of an under told story here is, the gains we continue to make with the A26 I think that the A26 is, we’ve indicated in the past, every A26 we sell is incremental market share, and that’s what we’ve seen it really doesn’t detract from selling X15s, as much as its back into a segment in its own right that’s in that 12 and 13 and 13 liter segment and we continue to make significant gains in both the number of A26s we sell, but in addition to that, the satisfaction and the feedback we’re getting from our customers and how much they like the product so couldn’t leave that particular question without also commenting what a great job the A26 is doing for us in the market.

[Abdul Tambal:]

Got it. thank you.

[Operator:]

Thank you. And our next question comes from Christopher Laserinko of Wells Fargo Securities. Your line is open.

[Christopher Laserinko:]

I’m on for Andrew Casey this morning. Just kind of continue in the vein, I knew that NAV is the only OEM to gain market share for the year, but any idea, what that stickiness looks like going forward once supply chain constraints start to loosen up around the industry?

[Michael Cancelliere:]

Yes, this is Michael. So, we look at our order board and the share gains we’ve made in 2018 and the customer preference of our products what’s important to customers is a fuel economy wade-up time driver preference, so that really speaks well for our LT and A26 our order board is up significantly, and we really moved into a phase, where customers went from about a year ago or so to trying a product to experience it first hand, to now really enjoying the performance and benefits they get keep in mind one of the biggest challenges the industry has is drivers so, it’s important for fleets to buy a product that their drivers like as at a traction and retaining tool in fact, they just got a call yesterday from a fleet with over he’s got over 1,000 trucks and recently purchased many of our trucks and just to quote him, we reference that he had a couple of veteran drivers called and say, boy, these trucks are phenomenal, the LT with the A26 are the quietest trucks they’ve ever driven and that, he felt very positive about the impact that would have on his business so, in summary, we’re optimistic about continued share gains in that segment.

[Troy Clarke:]

Yes, and let me – this is Troy let me just put it another way. I and Michael go back and we will give some numbers this is really only the third time in the history of the company that we have gained 2 percentage points or more in the heavy segment and I would tell you it’s the first time the company has ever done it and it did it profitably the previous two times the company did not do it profitably for a handful of reasons and the irony of the whole situation and I think you’re actually pushing on this, Christopher, is it one of our supplier constraints that we ran into in Q3, it would have been higher than 2 points 2.5 points of market share gain in the heavy segment it would have been in addition to that and so, we would be in the highest single year gain that this company has ever had we can only read and again with this anecdotal information that Michael says, which is one of, dozens of comments that we get, we can only read that we really have the product that has the ability to get real traction in the market and we’re very excited about what 2019 portends for us in that regard.

[Christopher Laserinko:]

Okay. I wonder if I could ask a couple kind of housekeeping questions and then get back to the market share. The housekeeping questions I have, any guidance that you are willing to provide for 2019 manufacturing cash balance and the second one is, you’re exiting this year with 30% incrementals give or take is it reasonable to expect that level of incremental going forward? Also anything that you’re willing to share in terms of decrementals if volume start to decrease? And then, on the market share side, if you do start to see those industry downturns, is there anything to prevent market share leakage like you’ve had in the past downturns and really kind of cement those gains other than kind of the understanding of new product launches, the reception of A26, etcetera?

[Troy Clarke:]

Yes. Well, so let me just hit the last one had on I mean there’s kind of the there’s the quantity of backlog and there is the quality of the backlog and certainly in light of the fact that this is an important subject for all of you and I think an important subject for the industry I would say over the last six to eight weeks, we’ve spent a lot more time, really understanding the nature of our backlog to ensure that number one, it’s not being overstated anyway but number two, how can we reflect you the confidence that we have, our cancellation rates are relatively low compared to the industry and the fact of the matter is we can tie a name to over 85% of our backlog and this isn’t just John Doe, these are names of some of the largest and most important customers in the trucking industry that we worked hard to create a different kind of relationship with so we have two things. One, we have a lot of confidence in the backlog and don’t believe we face massive cancellations which could be one cause for market share erosion as you have noted and then, I think the second thing is that, given the fact that the majority of the market share came from large customers it is not impossible, as a matter of fact, it is highly probable that in any market softening, our market share would nominally strength given the larger customer profile that our backlog is constructed of at this particular point in time so that’s just a comment on that I’m looking to Michael he’s nodding his head’s so I think I’m portraying it accurately let me pass over the incrementals to Walter.

[Walter Borst:]

Yes. Let me start with the cash first, which is we provided manufacturing cash guidance during the turnaround that was appropriate at that time, with $1.36 billion of cash at year-end this is not I think the most relevant metric going forward so we’ve provided a fair amount of additional guidance that you’ll see in the presentation deck, but we’re just trying to pay down debt with our cash and we’ll continue to make sure that we retain enough cash to run the business and make the investments in the future on incrementals, just kind of stick with the comments that we made earlier, which is that we do expect our truck margins to grow again in 2019 in my prepared remarks, I mentioned that we expect price increases plus additional cost savings we get from the procurement JV to more than offset the commodity headwinds and some of the other costs that we’re seeing in the in the market right now so I’m not going to comment on specific incrementals other than to say that both in the truck and in the parts segments, we expect margins to continue to be higher in ‘19.

[Christopher Laserinko:]

Okay. Thanks, guys.

[Operator:]

Thank you. And our next question comes from Brian Sponheimer of Gabelli. Your line is now open.

[Brian Sponheimer:]

Hi good morning everyone. Just a question on the defense business it’s nice little business for you, and so clearly there’s some trade-offs with you selling I’m just curious whether this business was a hurdle in any way to increase collaboration with Traton and either through engineering, through tech development or even through increased ownership by them above the 20% hurdle?

[Walter Borst:]

Yes, Brian, and the reason we did the transaction is we’ve had a very good run in defense, you see that in our 2018 results we are really kind of at a point now where incremental investments need to be made in the defense business and we’ve chosen to work together with Cerberus in that regard we think that portends to a very good future for NAV defense over time but we’ll split those investments with them and have additional cash that will take out of the transaction to put towards our core operations going forward so, we’ll continue to participate in the upside and defense with a 30% interest we continue to have an exclusive supply arrangement to that entity, and we’re partnered up with we think an excellent partner going forward.

[Brian Sponheimer:]

Great. And congratulations on a great year. Best of luck next year.

[Operator:]

[Operator Instructions] And our next question comes from Mike Baudendistel of Stifel. Your line is now open.

[Mike Baudendistel:]

Thank you. Just wanted to ask you about this Slide 14, the U.S. and dealer stock inventory and that seems to be creeping up and I just wanted to get some context of how much of that is the Class 8 versus the medium duty, and just any other sort of context at some of the newer products that you were just talking or just sort of any other context there?

[Michael Cancelliere:]

This is Michael. So really the dealer inventories are just growing levels that we consider more normalized levels throughout the year, the strength in the market demand has caused the inventory dealer inventories to dramatically decline, and what we’ve been doing throughout the year due to the challenges we had earlier in the year on supply constraints we were prioritizing customer deliveries over dealer stock units so they are now returning to normalized levels as we work through backlog, dealers are excited about our new product line they’re selling the more conquest customers than ever before, not only in number of units but number of customers and they’re moving out their old inventory and stocking up with the new product they recognize how important it is to have inventory on the ground they look forward to a positive 2019 and you can’t sell what you don’t have so they’re comfortable with those inventory levels.

[Troy Clarke:]

Yes, I think the inventory levels that we’re looking at is, as Michael indicated, we had the shorter dealers almost for a period of time to make sure we’re delivering to customers, who had ordered units rather than putting the units on the lot to your point, a lot of the medium duty stuff and some of the vocational stuff do go through dealers and so you see a very nice mix of products on their lots, not exclusively those they do also have heavy another Class 8 products and we’re kind of looking to keep them in a range and they’re looking to keep in a range of kind of 60 days of inventory, given the current sales rates and that’s kind of a ballpark that we’re in.

[Michael Cancelliere:]

Yes. And Troy if I may add the other important thing of the quality of the inventory the dealers is that we completed transition for the new products so now, the inventory that is on the ground is of new all the new models, the new MV, the new HV with A26, all the launches that we completed in the second half of this year.

[Troy Clarke:]

Yes. So, it’s pretty good – so it’s a pretty good quite frankly, we’re very pleased with where that inventory is right now, and I think the dealers are as well.

[Mike Baudendistel:]

Great, thank you.

[Operator:]

Thank you. And our next question comes from Erika Jackson of UBS. Your line is now open.

[Erika Jackson:]

Hi, I was just wondering if you can touch just a little bit on supplier constraints that you called out in Q4 I know it’s a strong industry and it looks like really bad but I guess, just specifically wondering, if you’re able to clear all the shipments that were missed in Q3 that I think you reflected, especially in Q4, and I guess to what extent you expect supplier constraints continue in 2019?

[Troy Clarke:]

Yes, what happened was, as we and the rest of the industry, I think ramped up their volumes much, much earlier in the year we as well as our contemporaries in the industry ran into the handful of supply issues from just a handful of suppliers we worked very hard with those to eliminate these bottlenecks some of which were very structural in terms of cooling capacity and things like that and by and large, as we entered the fourth quarter, those issues were resolved given that the market is up, the supply chain is really just pulled very, very tight right now and what would be traditional levels of buffers between suppliers and ourselves, they’re just not there and so any type of disruption, we had a couple of hurricanes for instance, we don’t tend to put stress on the supply chain what that does now, we’re in a mode is, it’s not so much that we lose units is that we have to incur premium freight so that we can expedite parts to keep the line running so, we’re not in a position today, where we lose units, as such we’ve added a second shift to one of our lines in Escobedo where we really are is we’re in a position where the cost, because of force majeure so to speak or acts of nature can be a lot higher than we planned but those costs continue to improve as the I think as the supply chain continues to stabilize the holiday period will be a great time, to be very honest, for some of our suppliers to refill those buffers and make sure that the not just ourselves but the balance of the industry is more normal when we go forward. Phil?

[Phil Christman:]

No, I think that you covered exactly right look, we’re confident in the strength of order board and supplier capacity put on additional shift in Mexico and we’re excited to build more units for our customers.

[Erika Jackson:]

Got it. Thanks. And then also just wondering if you have any expectations that you can share for the Class 4, 5 products, have you given like market share target or how about the effect that’s ramp up over this year?

[Troy Clarke:]

Yes. Well, we just introduced it in November and it’s a great product I mean the more I am around, the more I like it and of course, I guess I am kind of biased, but we had a launch event where we and I am going to turn it over to Michael to give you the specifics of it, but tremendous enthusiasm around this product is I think it’s going to do very well.

[Michael Cancelliere:]

Yes, Troy, exactly right. The launch event customers – the product was extremely well received. What they like is that there is finally a product offering by a true commercial truck, and in fact, one that understands the business and knows how to build a robust product give the customer flexibility and have the dealer network to support that product. So the receptivity has been really terrific by customers.

[Troy Clarke:]

Yes. We had about 300 customers there. And perfectly, I think we split the production with General Motors. We won’t go into the details on those numbers right yet, because not fully aware of what General Motors order profiles are, but I think that we’re quickly approaching that we’ll be kind of – I don’t want to say sold out, but we’re quickly subscribing the portion of the volume that, that we have allocated to ourselves. We find it’s a very unique product, right. I mean it’s got a 23-5 [ph] GVW and I think a normal Class 4/5 truck in that particular segment might be a 19-5 [ph] GVW. So it definitely has some additional capability that lets it play up, and this by the way is a growing segment. So we haven’t participated here for a while. We’re really excited to get into it and I think we’re going to surprise ourselves with how well we can do. But we’ll have to learn a little bit, because it’s a different set of customers in some cases, but we’re pretty pleased.

[Michael Cancelliere:]

Yes. Maybe Troy, if I can just add, the – this – because this is a new product and kind of a re-entry of a segment for us, but the Class 4/5 segment is about 85,000 units and part of it that will compete in is about half of that amount. So now there’s 40,000 to 45,000 units there that we can go after our fair share of. So just the kind of size the opportunity. I think both GM and Navistar have put their pricing out. It’s a little over $40,000 a unit, I think is where the MSRPs are 40,000 to 45,000. So, that will help you gauge this a little bit. And then for us, it’s two things. It’s one, it’s the sales of our units, which our customers are relishing to get into their hands is – was mentioned here, but then secondly, it’s also assembly of those vehicles for GM under our contract manufacturing arrangement, which will help then some of the fixed costs in our manufacturing facilities, in particular in Springfield.

[Erika Jackson:]

Got it. That’s very helpful. Thank you.

[Troy Clarke:]

Okay. Thank you.

[Operator:]

Thank you. And our next question comes from Seth Weber of RBC Capital Markets. Your line is now open.

[Emily McLaughlin:]

Hi, this is Emily McLaughlin on for Seth. One question on share improvement embedded in the 2019 outlook. Do you expect improvement across all core products or is there more of pick-up expected in certain vehicle classes?

[Michael Cancelliere:]

Yes, Emily, this is Michael. So, it would be a combination of all the vehicle classes. Again, we have the industry’s newest product line and customer receptivity has been terrific throughout the product. In fact, in November, while the industry shrunk 20% on heavy orders, our orders were up 102% year-over-over. Yes.

[Emily McLaughlin:]

Okay, great.

[Troy Clarke:]

Thanks, Michael. On the medium –

[Michael Cancelliere:]

Yes. On the medium side as well, we’re seeing a – we’ve recently launched the MV Series and our order share was up over 3 points on a year-over-year basis. In fact, our charge-outs were in excess of the industry growth last year, however, we weren’t able to get them all through due to delays in supply chain, as well as back up at body companies, but since we’ve launched the MV Series, the industry’s largest buyers have responded well to, and of course, a lot of customers who are waiting for it, they want to make sure they had the latest product and models particularly in the leasing industry where resale value is important.

[Troy Clarke:]

Yes. So we have backlog that basically supports increased market share we think across all of our product line up. It will be a little choppy because of the fact that some of this stuff has to go through body – through body manufactures and it will take longer for them to get registered. So the right thing to look at is basically our charge-outs and kind of year-over-year improvements in charge-outs.

[Emily McLaughlin:]

Okay. That makes sense. And then just a follow-up, do you have any thoughts on the spike in industry Class 8 cancellations in recent months and new orders, are you hearing anything from dealers in terms of the quality of new orders?

[Michael Cancelliere:]

Yes. So I think as we stated earlier, we believe our backlog is firm. The majority of our orders are sold, therefore, there – by customers, we, in many cases, done business with before and we’re confident that they’ll take the product. Our dealers don’t put trucks on order unless they’ve got firm orders from customers on it, as well as our dealer stock orders we believe are firm as well. We haven’t created environment where we’re asking dealers to put orders in for a 12-month period. So they pretty much put orders in on a short-term basis. They’re very bullish about the business, as well as their customers are optimistic about 2019, and the need to have new fuel-efficient trucks, that drivers like, that gives them – that impacts their bottom line and helps them make – become more profitable. So dealers won’t have trucks to sell and customers are looking to buy trucks particularly with a safety equipment on it to protect the driver and attract drivers as well. So we don’t see – we’re not overly concerned about cancellations on our order board.

[Emily McLaughlin:]

Okay. Thanks a lot, guys.

[Troy Clarke:]

Thank you.

[Operator:]

Thank you. And our next question comes from Rob Salmon of Wolfe Research. Your line is now open.

[Rob Salmon:]

Hey, good morning, guys. A quick follow-up with regard to the long-term supply agreement you guys have signed alongside the Navistar Defense kind of partial sale. How should we would be thinking about the revenue impact of this agreement? And if piece of the business are shifting from truck into the parts businesses as we look forward once its completed?

[Walter Borst:]

Yes. So I think what you’ll see – and again, we’ll provide some additional details around this after the transaction closes, but I think you’ll see two pieces, one, as I mentioned earlier in the call, Defense revenues will be down in ‘19 versus ‘18 given the outsized year that we had in 2018. And then secondly, once we go down to a 30% stake, we won’t be reporting the revenues from NAV Defense. We’ll just be reporting our equity interest there, but we will continue to have the MilCOTS sales to the venture and that will run through our numbers, that’s a fraction of the $534 million of revenue that you saw in ‘19.

[Rob Salmon:]

Right. And then Walter just as a kind of follow-p to that. I’m assuming you guys are going to add back the 30% to the adjusted EBITDA number from the minority interest? Am I thinking about that right or will that be excluded from the EBITDA prospectively?

[Walter Borst:]

No, the 30% of the future earnings will be in the adjusted EBITDA number, will be included, yes.

[Rob Salmon:]

Okay. I appreciate the time.

[Walter Borst:]

Okay, Rob.

[Operator:]

Thank you. And our next question comes from John Sykes of Nomura. Your line is now open.

[John Sykes:]

Yes. One question I had was, what’s the contribution that Class 6 and 7 make to revenues and EBITDA, do you guys disclose that?

[Troy Clarke:]

I don’t think we’ve broken that out separately, but you can – I think you get a good sense of what our volumes are in the back of the K.

[John Sykes:]

Okay. The next one is electrification. When do you really see that becoming a meaningful part of the business?

[Persio Lisboa:]

Well, John, I don’t know if you saw, but today we just announced that we are creating an eMobility business unit. I think Troy alluded that on his remarks. We – that is a reality right now for us. We’ve been working on the technology for some time. Actually, Navistar was one of the first commercial vehicle companies to introduce our eStar back in 2010. So we have a lot of experience in the field and one of the things that we decided to do right now is really to expand our reach in the business more beyond the technology. We are really waiting to get into the what we call this procurement experience for eMobility, which is really about the specs that the customers will help specing vehicles, will help developing vehicles, will help actually with financing of vehicles and available grants. The idea is that we work on infrastructure and service network to support those vehicles, that’s what these business unit is about. And to lead that business unit, we just brought to the company today one of the most reputable executives in the market, Gary Horvat. He was the CTO for Proterra, and he is really now kind of joining the team right now. So, more to come. So, that’s a reality for us, is one of our priorities for the future.

[John Sykes:]

So what is the – so the game plan is to sort of start with this eMobility business, get kind of an infrastructure type of business in place. And I mean, I’m assuming like the product it – so it’s easy for you guys to make an easy truck, right?

[Persio Lisboa:]

Well, no, I think it starts with the product, but not really. Now, I think the fact that we have the largest dealer network available in the market and the fact that we are in contact with customers that also want to buy diesel products today. So, we are really focusing on enabling the electrification in the segment beyond the product, I would say.

[Michael Cancelliere:]

Yes, I mean, I think well, here is how we’re looking at it, really starts with the customer, right. So, we’re going to go out. So, we have customers. We know customers who – they have an interest in the technology and we believe the technology will work for them in such a way as to be manageable and/or improving their TCO at some particular point in time. And so those are the customers that we really have to kind of lean toward forward in our solutions. And we’ve indicated previously that the place where we think is most makes sense are school buses, okay, which –

[John Sykes:]

Right, okay, yes.

[Michael Cancelliere:]

[Multiple Speakers] and medium-duty trucks because in both cases, the charging infrastructure is less significant than it is with, so to speak a non-highway tractor. We have said previously we’ll have trucks on the road next year and we’ll have trucks in customers’ hands the year after.

[John Sykes:]

Okay, yes.

[Michael Cancelliere:]

But what Persio really references is, look, there’s a lot of cycles of learning here, right. I mean, this is a field that you can spend a lot of money and there could be a lot of upside customers, when they decide while the electric vehicle that I just spend a lot of money for really doesn’t satisfy my needs. Quite frankly, we’re looking to have a very successful experiences for us and our customers and we think our approach will lead us in that direction. Again, as Persio indicated, we’ve been working on this stuff since much earlier in the decade. So we have some pretty developed thoughts.

[John Sykes:]

Yes. I mean, I guess the kind of the genesis of my question is suppose regulations change in certain states, right? And they start saying, you can’t bring a diesel truck into the city limits, it’s got to be EV at that point. So then can you guys – are you guys ready if that happens to boom, we have a product?

[Troy Clarke:]

That’s our goal. I mean, that’s our goal, I mean strategic flexibility, you are right. That’s what – you don’t see that exact circumstance today, but I think here at Navistar, we are ready with alternatives.

[John Sykes:]

Okay. No, that’s – and then I guess, lastly, it sounds like 2019 is going to be a decent year, right. And I know we don’t want to look too far forward, but how do you sort of – I mean, you’re doing a good job with the balance sheet. So you’re taking out kind of a lot of volatility in the balance sheet. But how do you really take out volatility in the business just given it’s a cyclical business, and like the parts business, it’s never going to be enough. I don’t think to compensate for the Class 8 business, for example. So how do you really smooth that out and make it less cyclical over time.

[Troy Clarke:]

Yes. Well, first of all, 2019 is going to be a great year.

[Michael Cancelliere:]

Great year.

[Troy Clarke:]

Okay. So, not a good year, it’s going to be another great year and the only thing I want to share [Multiple Speakers]

[John Sykes:]

I want to think it is, I guess.

[Troy Clarke:]

Yes, I think you did. We are planning to put up better results as you see in our guidance. We’ve got the newest product line up in the business. We’ve got a lot of market share that we can still grow. And so I mean, if you look to the future, we’re doing a couple of things and these are not new things, but really we see upside on revenue growth, and then we see the ability to further improve our margins by reducing our costs, taking advantage of the alliance, both the global scale that the alliance brings, as well as the integrated powertrains that we’ll be introducing into our product. So our goal as the management team continues to be profitable at all points of the cycle and continue this positive free cash flow that we see it here in ‘18 and will continue into ‘19 in the future, so that we can continue to improve even further on those balance sheet actions that you referenced.

[Michael Cancelliere:]

Yes. I mean, we think it’s pretty straightforward and we think we’re very compelling, something other than a cycle play because we’ve already done so much to improve our margin, okay, and we have more opportunity, again, through two strategies primarily, one is global scale through the procurement joint venture and the second is getting into the integrated powertrain. And then ultimately, the parts revenues that basically come, that basically kind of come out of that. And then we have this tremendous opportunity for upside market share. When you look at our historical market share and the success we’re having in the market today, so we control revenue against that, okay that – and then that spins off cash that lets us put the balance sheet in order. And when you look at that, you say, wow, those are the three things that are really important, not the cycle, okay, because of the fact that we have this ability to function in a profitable range at all points of the cycle.

[John Sykes:]

Okay. Yes, I mean –

[Michael Cancelliere:]

That’s the way I would tell the story, obviously.

[John Sykes:]

Yes. It seems like 4 through 7, that never seems to be that overly cyclical versus Class 8, right? So, what are you seeing?

[Michael Cancelliere:]

Yes, no, that’s true. And we have a big footprint in that 6 and 7 space. Now, we have the opportunity to increase that footprint. Alright. We probably should move on to the next question.

[John Sykes:]

Yes.

[Michael Cancelliere:]

Well, thank you, John for your interest.

[John Sykes:]

Yes. Thank you.

[Operator:]

Thank you. And our next question comes from Jerry Revich of Goldman Sachs. Your line is now open.

[Jerry Revich:]

Yes, hi, good morning, everyone. Walter, I’m wondering if you just spend a little bit more time stepping through the moving pieces around the EBITDA guidance based on the top-line guidance, it looks like you’re only guiding to 7% incremental margin. In fact, earlier in the call, you both spoke about price cost is positive, and so can you just step us through any headwinds to incremental margins in ‘19? Are you folks just giving yourselves room to execute? Any piece of it you want to flush out better headwinds that were maybe missing?

[Walter Borst:]

Sure. So let’s just go through the pieces again. We expect gross margins to be higher in ‘19. We indicated 19% to 19.5%, so, that’s up about 0.5 point from what we saw in ‘18, and it’s the things that you mentioned, pricing, we expect to be favorable. We expect to realize further benefits from our procurement activities, including from the JV and that will help offset some of the headwinds that we are seeing in commodity prices and freight costs. If commodity prices were to come down as we’re starting to see them decline a little bit, then that could be a positive, of course. The EBITDA margins are flat. I think that’s what we’ve kind of guided to at the midpoint year-over-year, because we are making some investments in our future, in particular, future product engineering investments. So, we’ve mentioned previously in our calls that while our engineering spend will be more efficient going forward as part of the alliance with the Traton Group, that doesn’t necessarily mean that they will be lower going forward as we invest in these integrated powertrains, which will then drive our results in the future. So the initial guidance is relatively flat on EBITDA margins, but that’s going to set us up for success in the future in a few years of how we still want to be getting our EBITDA margins up to 10%.

[Jerry Revich:]

Okay. Thank you. And then in terms of – I know it’s not the base case, but if the market were to turn negative, exiting ‘19, I think typically for OEMs, we see mid-teens type decremental margins. Troy and you folks are obviously have a lot of irons in the fire in terms of what you folks are working on. What would you expect your decremental margins to look like compared to the mid-teens that we typically see once the cycle moves the other way? And I appreciate that that’s not your base case in ‘19, but would love to understand how you’re thinking about the dynamic whenever the cycle does turn?

[Walter Borst:]

Yes, that’s probably little bit too much specificity today. Maybe that’s a good question for a Analyst Meeting or something, some time. But I think the key drivers for us, Jerry, will continue to be what we’ve referenced a couple times on the call. We’re bullish on our ability to grow revenues and we’re bullish on our ability to continue to reduce our costs, in particular on the – through the procurement JV that we have. So that will help weather any downturn as well. In fact, downturn that you’re alluding to, we probably wouldn’t have some of the headwinds that we currently have on commodity prices, for example. So that wouldn’t be replicated in the subsequent year after ‘19, as we see it as a headwind here in the current fiscal year. So our focus is going to be on those two things; growing our revenues, even in a down market, we should be able to grow market share and continue with our cost initiatives and that should allow us to be profitable at all points on the cycle.

[Operator:]

Thank you. And that concludes our question-and-answer session for today. I’d like to turn the conference back over to Mr. Troy Clarke for closing remarks.

[Troy Clarke:]

Okay. Hey, thanks to everyone. Look, I apologize I have a little head cold. So, it was difficult to hear me earlier in the call. I apologize for that. Look, we have been talking to some of you, several of you every quarter for the last 6 years and quite frankly, we appreciate your interest and your understanding of the issues and steps that we have taken on our journey. And the questions you have asked are certainly welcome and insightful and in many ways has helped us become a better company and we appreciate that. And I certainly hope that my nasally voice doesn’t mute the enthusiasm that I have personally for not only the progress that this company has made, but the progress that we can make starting with 2019. 2019 is going to be, as Walter indicated in one of the final questions there, a great year for the industry and a tremendous year for us to make additional progress. And we are very enthused about it. And again, we appreciate your interest in understanding of our industry. Want to wish all of you a happy and joyful holiday season. Look forward to talking to you at least in March. And as Walter indicated, maybe we will look for an opportunity to have another communication event that we can manage somehow during the course of the year.

[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.