Navistar International Corporation
Q2 2016 Earnings Call Transcript

Published: 7 Jun 2016

[Operator:]

Good day, ladies and gentlemen, and welcome to the Navistar second quarter 2016 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 follow at that time. [Operator Instructions] As a reminder, today’s conference is being recorded. I would now like to turn the conference call to Jon Peisner. You may begin, sir.

[Jon Peisner:]

Thanks, Kevin. Good morning and thank you for joining us today for Navistar, Inc. second quarter 2016 earnings conference call. Today, we will discuss the financial performance of Navistar International Corporation for the quarter ended April 30, 2016. Joining me today are Troy Clarke, our President and Chief Executive Officer, and Walter Borst, our Executive Vice President and Chief Financial Officer. After concluding our commentary, we will take questions from participants. In addition to Troy and Walter, joining us today for the Q&A session are both Bill Kozek, President of Truck and Parts, and Persio Lisboa, President of Operation. Before Troy kicks off our discussion, I would like to remind you that this conference call contains forward-looking statements within the meaning of the federal securities laws. Investors are cautioned that such forward-looking statements involve risks and uncertainties that may affect Navistar's business prospects and results of operations and such risks are fully detailed in our SEC filings. In providing forward-looking statements, the company expressly disclaims any obligation to update these statements. Lastly, let me mention that throughout this conference call, we will be referencing both GAAP and non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the applicable GAAP financial measures can be found in the press release that we issued this morning as well as in the appendix of the presentation slide deck, which are both available in the investor relations section of our Web site. And finally, we refer you to the Safe Harbor statement and other cautionary notes disclaimer presented in today's material for more information on the subject. Now, I’d like to turn this call over to Navistar CEO, Troy Clarke. Troy?

[Troy Clarke:]

Okay. Thanks, Jon, and thank you, everyone, for joining us this morning. I'll be covering the quarterly highlights, then turning it over to Walter for a more in-depth discussion of our financials and then we'll take your questions. So let me start with a few headlines. First, we were profitable during the second quarter, making this the first quarter when Navistar has turned a profit since the third quarter of 2012. I think this quarter begins to demonstrate the earnings potential of this company. The fact that we made a profit in Q2 despite lower Class 8 truck volumes that impacted the entire industry underscores the tremendous progress we continue to make. Although revenues were 18% lower year-over-year, our adjusted EBITDA for the quarter rose 83% year-over-year to $187 million. Our Truck segment profitability improved $28 million year-over-year. And excluding an adjustment in pre-existing warranty, the segment would have been profitable in the quarter for the first time since we started our turnaround. We saw record performance during this quarter from our Parts segment, which was driven by strong US commercial performance and growth in our Fleetrite all-makes parts business. And thanks to restructuring actions and continued cost improvements, our Global Operations segment achieved essentially breakeven results on 41% lower sales. These are all positive developments. That said, we are taking only a moment to celebrate this quarter's milestones. We're immediately pressing ahead to address what we and everyone else in the industry are seeing, much more difficult industry conditions than anticipated, primarily in Class 8 where we’ve lowered our industry guidance range by 20,000 units. As a result of this reduction and other items that Walter will address shortly, we’re reducing our full-year revenue and adjusted EBITDA guidance. While we were net income positive in Q2, it will now be difficult for us to be profitable and free cash flow positive for the year as we now see it. We’re responding to the soft industry conditions by taking additional steps on both the cost and the revenue sides of our business. One thing Navistar has proven is our ability to deliver on cost management. In fact, we are on track to well exceed our full-year target of reducing total costs by $200 million. And we intend to build on this in the second half. We’ve done a great job of managing structural costs. We’ve identified additional SG&A reduction opportunities in the second half and our engineering operations continue to pursue product development efficiencies. Our procurement team is focused on incremental reductions in material cost and we continue to make progress on our focused factory strategy and lean improvements at our manufacturing plants. On the revenue side, our sales team is taking additional steps to offset the headwinds in Class 8s. Medium, severe service and bus continue to be solid markets. We’re well positioned in these markets and we’re doubling down on our efforts to get in front of both current and [Conquest] [ph] customers. This quarter, we enhanced our powertrain options for medium and severe service customers by adding the Cummins ISL 9-liter engine as an option for our International DuraStar and WorkStar models. We also launched our new HX Series of premium severe service vehicles, which is now in production. The HX Series has been very well received with order intake running ahead of plan. In fact, we’ve already secured more than 70% of our planned HX Series orders for the year. The HX Series is the first of several new truck products we are planning. As we indicated on our last call, we are at the early stages of renewing our entire product portfolio with Project Horizon. Over the next few years, we plan to launch new vehicles every four to six months. This reinvestment in our product line will culminate in 2018 with an expansion into the Class 4 and 5 vehicles through a partnership with General Motors. These new products are based on careful research into what makes our customers successful and what drivers need to be more productive. And we’re confident that they will enhance our customer value proposition across all segments and provide additional profit opportunities. Our connected vehicle strategy has become a real point of differentiation for international trucks. During the quarter, we surpassed the 200,000 subscriber mark for OnCommand Connection, our unique open architecture remote diagnostic service. This has grown very rapidly since we launched it in just the fall of 2013. And at the end of May, we are at 220,000 connected trucks. OnCommand Connection recently earned Navistar the prestigious CIO 100 Award from CIO Magazine. This is a recognition of companies that exemplify the highest level of operational and strategic excellence in developing and use of information technology. OnCommand Connection is helping our customers achieve significant improvements in uptime for their trucks and buses, regardless of make. This quarter, we also announced another connected vehicle innovation, our launch of the industry's first over-the-air programming service. Over-the-air programming offers a major enhancement in customer convenience and enables drivers or fleet managers to initiate engine programming over safe, secure Wi-Fi connections, speeding the customers’ access to updated engine calibration as it delivers superior performance, fuel efficiency and other benefits. We also recently announced that we have become the first truck OEM to offer over-the-air programming with Cummins engines, including Cummins engines and vehicles not built by International. These new and expanding connected vehicle services are helping the company and our dealer network reduce downtime in the time a truck spends at a dealer. We call it service dwell time. And are also driving progress towards our goal of providing industry-leading uptime. To sum up, we just completed an important quarter, one that shows the benefits of strong cost management as well as lean enterprise efforts and our ability to earn a profit despite industry headwinds. At the same time, we continue to make significant investments in new products, services and technologies that set us apart from the industry. And while the second half poses new challenges due to softening industry conditions, we are a resilient organization and we intend to deliver the best achievable results, while strengthening the company for long-term success. Let me turn it over to Walter and we’ll go into the numbers in a little bit more detail.

[Walter Borst:]

Thank you, Troy. And good morning, everyone. As Troy indicated, the second quarter was a strong quarter for Navistar, despite industry and global headwinds. I echo Troy's excitement about our return to profitability this quarter. This performance also demonstrates our ability to take further costs out of our business and to be profitable even with lower revenues. We also grew our manufacturing cash balance from where we ended Q1. With that introduction, let me walk you through our income statement highlights, review our segment performance, and provide an update on our expectations for the remainder of the year. Details for my comments can be found on the slide deck which we posted to the investor relations page of our Web site. Turning to the results for the quarter, we achieved profitability on consolidated revenues of $2.2 billion, which were down 18% compared to the second quarter of last year. The revenue decrease was largely driven by a 15% reduction in our core charge-outs to 15,800 units. This decline was primarily due to soft Class 8 industry volumes, which impacted our core US and Canadian markets. The year-over-year decline also reflects the impact of the Blue Diamond Truck joint venture that ended in April of last year, which accounted for $122 million of revenues in Q2 2015. Additionally, engine volumes in Brazil were substantially lower due to the ongoing weak economic conditions in that region. On the plus side, Parts grew revenues by $34 million in the quarter, driven by strong US retail sales effort. Our net income for the quarter was $4 million versus a loss of $64 million in Q2 2015. Q2’s diluted earnings per share was $0.05 compared to a loss of $0.78 in last year's second quarter. The results reflect substantial savings from companywide cost reduction actions, achieved by reducing structural costs as well as through product cost improvements, including some favorable commodity impacts. As noted in our press release, we’re on track to well exceed our $200 million structural and product cost reduction goal for 2016. Adjusted EBITDA grew to $187 million versus $102 million in the same period last year. In Q2, adjusted EBITDA margin more than doubled to 8.5% versus 3.8% last year. The results for the quarter were negatively affected by a $46 million adjustment to pre-existing warranty, which resulted from approximately equal impacts to our medium-duty and big bore engine families. These issues were driven by an increase in frequency and cost of repair for both platforms. It’s important to note that warranty expense excluding pre-existing adjustments remains below 3% of manufacturing revenue and we continue to work to drive towards best-in-class quality levels. We also had $6 million of charges for restructuring and asset impairments in the quarter. Now let’s dive into the results for our segments. Truck sales were $1.5 billion, down 25% compared to the prior year, due to 19% lower Class 8 heavy industry volumes in the quarter and the end of the Blue Diamond Truck joint venture. The Truck loss narrowed to $23 million compared with a loss of $51 million in last year’s Q2. This improvement reflects the companywide efforts to improve our cost structure as well as a shift in product mix. Keep in mind that the loss of $23 million includes $46 million of pre-existing warranty charges. By comparison, in the second quarter of 2015, we recorded $19 million of pre-existing warranty charges. Parts sales increased 6% to $647 million versus $613 million in the prior year due to strong performance in our commercial business despite a soft industry. Higher Parts revenues reflect our focus on retail programs and double-digit growth in Fleetrite sales, our all-makes brand. The improvement was partially offset by a decline in sales of Blue Diamond Parts due to a gradual decline of units in operation. Parts profitability rose 32% to a record $176 million, reflecting both margin improvements and savings from cost reduction actions. We’ve taken a number of actions to improve the cost structure of our Global Operations segment as it continues to be impacted by weak economic conditions in Brazil. As a result of these actions, we achieved essentially breakeven results, despite the fact that revenues were down 41% for the quarter. The Financial Services segment continues to perform well. Q2 revenues were down slightly, but profits rose $3 million or 14%. This performance reflects gains of lease terminations, a decrease in loan loss provisions, and cost reduction initiatives. Turning our attention to used truck inventory, we ended the period with $448 million of gross inventory. The reserve increased in the quarter by $23 million and stands at 38% of assets. In part, the reserve adjustment is due to generally lower domestic used truck crisis. In addition, we lowered the carrying value of certain used truck inventory targeted for export markets. Excess used truck supply is an industry issue, which we believe could be with us for the next couple of years. As a result, we expect used vehicle prices to remain soft for the foreseeable future. As discussed in the first quarter call, we continue to attack high used truck inventory levels by judiciously driving trade receipts lower and aggressively pursuing domestic and export markets sales opportunities. Turning to cash, manufacturing free cash flow turned to a positive $28 million in the quarter. We ended the period with $732 million of manufacturing cash. During the quarter, the primary uses of cash included annual incentive compensation and benefit payments as well as severance payments of $84 million, interest and tax payments of $60 million, capital expenditures of $24 million and warranty payments in excess of expense of $14 million. Additionally, Q2 manufacturing cash balances reflect proceeds from the sale of the Pure Power Technologies business, intercompany activities including a $30 million dividend from NFC and other cash and non-cash adjustments. We expect to continue to build cash balances during the second half of the year from EBITDA performance and working capital improvements. Recently, NFC completed deals to refinance three key credit facilities, including its VFN facility which is used for wholesale financing, our track facility which is used for account financing, and our bank credit facility which can be used for either wholesale or retail financing. The completion of these facilities demonstrates the support of our core bank group. NFC has sufficient access to liquidity to continue to finance truck sales to quota dealers and help Navistar sell trucks. In terms of our guidance, we expect lower Class 8 industry volumes for the remainder of 2016 and have lowered our forecast range by 20,000 units to 220,000 to 250,000 units for the year. This compares to 279,000 units in 2015. Similarly, we’ve reduced our 2016 Class 6 to 8 and bus industry volumes to 330,000 to 330 60,000 [ph] units. Softer industry volumes has resulted in dealers drawing down their inventories, further reducing our production forecasts. In addition, larger customers have deferred orders such that we no longer believe we’ll be able to increase our market share as much as we'd originally expected heading into the year. We’ve also reduced our expectations for export volumes in the back half of the year as economic conditions in many parts of the world remain tepid and the stronger US dollar increases local prices. Accordingly, we’re reducing our revenue outlook to $8.2 billion to $8.6 billion from our previous estimate of $9 billion to $9.25 billion and our adjusted EBITDA range to $550 million to $600 million for the year. Given the slower industry sales environment and change in our adjusted EBITDA guidance, it will be more difficult for us to achieve our earlier stated goals to be profitable and free cash flow positive for the year. We believe we’ll end the year with about $800 million in cash on lower EBITDA estimates and working capital impacts from lower volumes. However, this in turn should result in less of a working capital unwind in in Q1 2017 in what is typically our weakest unit volume quarter. And we continue to believe that we have enough liquidity to manage the business. In summary, we’re proud of our employees’ efforts to return the company to profitability in Q2. Our second-quarter results clearly demonstrate Navistar's resiliency in the face of lower volumes and the long-term potential once volumes begin to improve again. With that, I’d now like to turn it back to the operator for Q&A.

[Operator:]

[Operator Instructions] Our first question comes from David Leiker with Baird.

[Joe Vruwink:]

Hi. This is Joe Vruwink for David.

[Troy Clarke:]

Hi, Joe.

[Walter Borst:]

Good morning.

[Joe Vruwink:]

Just a level deeper on the guidance update, so you mentioned not hitting your market share objectives in the back half of the year. If I just take the revenue change in guidance and assume an ASP, it looks like you're maybe expecting 5,000 to 6,000 fewer deliveries, which against the 20,000 unit market cut, is a pretty big market share target on that lost volume. Is that the right way to think of it? And then, what gave you the confidence originally to have such high market share entering the July and October periods?

[Walter Borst:]

So I think that’s directionally correct, Joe. We are reducing our volumes not only for what we see in the market, but also due to lower dealer inventories as they reduce their own inventories and lower market share expectations for the second half of the year, which we had expected to be stronger than currently. That said, we’re still seeing good improvements or improvements in share in several of our segments year-over-year. So with that, maybe let me turn that over to Bill.

[Bill Kozek:]

Sure. Hi, Joe. It’s Bill Kozek. I think your question is really around the heavy segment, specifically, what leads us to believe we’re going to grow share. Our order intake is up two percentage points year-over-year. So that’s reason to anticipate share growth in the second half. We’re down 1% in retail year-over-year in the heavy segment and that’s predominantly due to some of our larger over-the-road and leasing customers, not buying what we – not buying the amounts or the volumes that we had forecasted for 2016. So I expect that to improve in the second half. But our order intake is reason to believe that the second half share will improve.

[Troy Clarke:]

Yeah, Joe. This is Troy. Look, it’s kind of straight forward. The industry had a backlog to build off, okay? Us and other competitors. So if you look earlier in the year, you begin to see a disconnect between orders and deliveries. Now, quite frankly, that backlog is kind of coming off from us and our competitors as well. And so, order share is probably more representative of where you think market share is going in the future. At least, that’s one of the reasons why we choose to look at it that way. If you go back to the whole year and you say why do you think we could gain market share, look, this is really a market of a very manageable number of customers. And we build our plan this year on customers we believe would be in-market and on assumptions – from communications with them on the number of units that they would buy. As the year develops, some of those people are, turns out, not in market, and then some of those people that did buy bought fewer units than we had originally placed in our plan. So like I think all of our competitors, you could identify the market share plusses or minuses with really a handful of transactions that are in your plan that may or may not take place for both economic – or the economy and other circumstances.

[Joe Vruwink:]

So the market weakness isn’t a surprise. I guess what's notable is that at a point in time before use values and pricing and freight volumes etc., have done what they've done year-to-date, you are hearing from customers about a number that would imply 20% share of the Class 8 market whereas you've been running low teens for a while now. I guess the question becomes, if the market environment improves, is that still a right number or is that just too aggressive in retrospect?

[Troy Clarke:]

Yeah. Joe, I can’t put my arms around the 20% that you reference, to be very honest. But it was, to your point, a number higher than what we’re performing today. So the math can work that the number goes up, but that 20% range is – again, we’ll have to maybe spend some time with you on the phone to try to understand how you came up with that number because that's not a number that would – that I think we’ve talked about in the past.

[Joe Vruwink:]

Okay. Yeah, I’ll go back offline.

[Troy Clarke:]

No, that’s good. We’ll help you get your arms around that, Joe. The phenomenon you talked about is correct. We just need to get you calibrated in the right spot.

[Joe Vruwink:]

Sure. Thank you.

[Troy Clarke:]

Thank you.

[Operator:]

Our next question comes from Jeff Kauffman with Buckingham Research.

[Jeff Kauffman:]

Thank you very much. Can you guys hear me?

[Troy Clarke:]

Yeah.

[Jeff Kauffman:]

Okay, thank you. A quick question. Walter, when I looked at your forecast, you gave a decent top-down view. But you had the manufacturing cash guidance down $1 million to $200 million from the previous view on an EBITDA adjustment of about $50 million net-net. I think I know the answer, more reserve related. But what’s making up those differences.

[Walter Borst:]

You’re checking me, Jeff. It’s working capital in addition to the EBITDA reduction with less units in the second half of the year, and in particular in the fourth quarter than what we’ve previously estimated. There will be a working capital impact, in addition to the EBITDA impact. But as I mentioned as well, as we then go into Q1 which is typically our lowest unit quarter, we would see less of an unwind in working capital given where we would end up this year on working capital as well. So I’d ask you to think about both of those pieces.

[Jeff Kauffman:]

Okay. And that’s related more to a decision to slow down the trades and bring in orders more in line with inventory. Just the idea is, we’re going to hold this inventory longer, consume a little more working capital.

[Walter Borst:]

The working capital I was referring to relates to accounts payable and the like in terms of when we pay our suppliers versus when we sell the trucks. There’s an additional question in there on used inventories. We can talk about that as well.

[Jeff Kauffman:]

Okay. Well, I don’t want it to take away from the fact that it was a strong quarter in a tough environment. So thanks a lot, guys.

[Troy Clarke:]

Thank you very much, Jeff.

[Operator:]

Our next question comes from Ann Duignan with JP Morgan.

[Unidentified Analyst:]

Good morning. This is Tom [Simonich] [ph] on for Ann. Can you tell us what you’re hearing from customers in the various subsectors of medium duty and what are your expectations for orders in those subsectors for the remainder of the year?

[Troy Clarke:]

The medium-duty segment has continued to be strong this year. And the top sub-segments are lease rental, retail, general freight, construction, government, and those are all up year-over-year with the construction piece up the most significant. We do expect continued growth in those segments, the remainder of this year, and our customers are pretty positive. The one area that has also grown that we do not have a product in as of today is the gasoline piece of the medium-duty, which is we anticipate about 8% of the total market. So that’s one piece that we see long-term an opportunity for us. But, overall, the medium-duty segment continues to outperform where we thought it was going to be.

[Unidentified Analyst:]

That’s helpful. Thank you. I’ll pass it on.

[Troy Clarke:]

Thanks, Tom.

[Operator:]

Our next question comes from Brian Sponheimer with Gabelli.

[Brian Sponheimer:]

Hi. Good morning, guys.

[Troy Clarke:]

Good morning, Brian.

[Brian Sponheimer:]

So terrific performance despite obviously difficult conditions. Walter, if you could spend just a minute trying to maybe quantify the difference for that low point next year from a working capital outflow standpoint, it would help maybe – help us understand kind of where the nadir in cash could be for 2017.

[Walter Borst:]

Yeah. Let me try to answer your question this way because we’re not going to get into the guidance for 2017 today. But that $800 million of cash at the end of the year, we’ve previously said we needed about $500 million to run the business and that’s typically a function of how we’re ending the year and going into the first quarter which tends to be the quarter that we use the most cash. But that’s still a good level going in. And then based on the volume assumptions that you’d have in your model for the fourth quarter and the first quarter, you’d have to take a look at the working capital unwind. But my point is that the working capital outflow in Q1 should be lower than normal given that the Q4 volumes are expected to be lower than what we had in Q4 of 2015 as well.

[Brian Sponheimer:]

Okay. And I guess a follow-up to that would be, one, with everything you guys are doing on the positive and the one question that remains is the liquidity. And while you talk about having certainly enough to run the business, what would your thoughts, Troy, I guess, about exploring a partnership to maybe ensure that bridge in its entirety and really put you guys in a place to really reap the benefits of all the work that you’ve done in the last three or four years?

[Troy Clarke:]

We’re always open to things that make that make strategic sense for the company. We won’t speculate on the call what some of those might be obviously. But I would point to, when we look at things like the Class 4/5 project with General Motors that we put together, we do those kinds of things. So let’s not speculate on the call though. I think really the kind of things we’re doing are the kind of things that need to be done under any circumstances. The second quarter was, to your earlier point, Brian, I think no trivial feat, the plans and actions come to place and we really – despite an industry that was down – charge-offs – or revenue that was down 18% year-over-year, for us to post profitability really talks about the earnings potential that this company really does have.

[Brian Sponheimer:]

Right. No, congratulation on that. Just one clerical thing, though, if you were to be engaged in some sort of discussions, at what point would you need to make them public?

[Troy Clarke:]

Truthfully, I guess I’d have to talk to my counsel about that. But there is nothing for us to comment on at the present time.

[Brian Sponheimer:]

I understand. Thanks, guys.

[Operator:]

Our next question comes from Stephen Volkmann with Jefferies.

[Stephen Volkmann:]

Hello, good morning.

[Troy Clarke:]

Good morning.

[Stephen Volkmann:]

A couple of things maybe, if we could, just on this warranty charge. It seems like we had sort of been out of the woods on that for a while and now, I guess, we’re back a little bit to that issue. And I wonder if you can give us a little more color on that. Was it a specific problem that sort of popped up? Is it just kind of a widespread hodgepodge of things or how do we get comfortable that that's sort of not going to come back and be an ongoing thing?

[Persio Lisboa:]

Steve, this is Persio. First of all, these are very specific issues. As Walter alluded in his comments, we had part of the adjustment, the pre-existing adjustment happened between two families of medium-duty and big bores. Medium-duty as, I think, we mentioned to you before, in the last quarter, we had some adjustments taken with the supplier quality issue that we faced and we saw some increases in the cost per repair on that specific one. And we also noticed higher frequency for some emission components late in life failures that we had, but that’s something that’s discovered under warranty normally in North America that for all emission components going through five years. So those are very specific issues. And in the big bore platform similarly, our SCR products are performing on a much lower warranty cost than the initial EGR products. But as we launched the SCR, we had some our estimates and actually we saw some increases in a specific failure rate for the initial families for the SCR. Actually, we put corrective actions in place, implemented early last year, so it's been out there for a while and that's part of the adjustment that we had on big bores as well. So it is a very contained population. We don't – it is adjusted in the model right now and we are very confident that we have it corrected and we know how to address it in the future. So this is much different than anything you saw before.

[Stephen Volkmann:]

Okay. To the extent they are supplier related, can you get reimbursed for some of this or is that not the way to think of that?

[Persio Lisboa:]

Absolutely. We are working on that right now, and so we have part of that that will come back. We’re confident that we are still going through the process with the supplier, but we should expect something like that. Yeah.

[Troy Clarke:]

Steve, sometimes when that comes back to us, by the way, we don’t take it as a reversal of the accrual because it will come back to us in a different form of economics, right, as we may be in the pricing discussion or something like that. But that’s the normal course of the way we do business between ourselves and our suppliers. And I would highlight to you we enjoy great support from our suppliers on these type of issues.

[Stephen Volkmann:]

Okay, that’s helpful. Thanks. And then maybe switching a little bit on your guidance summary that you provided where you gave us the various changes. We talk about cost reductions being greater than $200 million. Is the greater than $200 million in the new guidance greater than the greater $200 million in the prior guidance?

[Walter Borst:]

That’s a good catch. That’s why we added the word well exceed. Yeah, it’s greater than the greater previously.

[Troy Clarke:]

I think we’re running out of adjectives.

[Walter Borst:]

We’ve done really well on the cost side and are really ahead of plan in the first half of the year. So we’re going to get the benefit of that over the balance of the year as well.

[Stephen Volkmann:]

And will any of that benefit slip into 2017? Will there be any sequential improvement in 2017 relative to 2016?

[Walter Borst:]

Yes.

[Stephen Volkmann:]

Great. Okay. Thanks.

[Operator:]

Our next question comes from Joel Tiss from BMO.

[Joel Tiss:]

Hi, guys. I just wondered if you could…

[Troy Clarke:]

Good morning.

[Joel Tiss:]

How is it going? I wondered if you can give us an idea what's left to do on the parts business to drive growth and profitability?

[Bill Kozek:]

I’ll take that, Joel. The Parts business continues to be very strong for us. Our Parts team has done an outstanding job. I do believe they are the best in the industry. As we look forward, they are the guys that are carrying this uptime mission and they're moving forward with kind of new and creative ways to continue to grow our Parts business. Obviously, OnCommand Connection helps in many ways, but we also have, as Walter mentioned, the Fleetrite program which is our all-makes business and helps the older population of vehicles. And then the other part of that is now that we have access to the Cummins business, that expands our opportunities into competitive makes for our dealership. So there is growth opportunities in that piece of the business as well. So while our proprietary engines may be down, we do have some other opportunities to grow our Parts business as well. And I know our team is working on those, as we speak.

[Joel Tiss:]

That’s great. And then I know you don’t want to give a 2017 forecast and maybe we could fuzz it up a little bit and just can you give us a sense of how the industry is shaping up for 2017.

[Bill Kozek:]

As I look at 2017, I see probably in terms of medium, severe, and bus, it’s going to stable, but maybe slight growth. The heavy piece is where we’re looking challenged. And if there's – if some things happen, I anticipate a little bit of growth there, but that’s going to continue to be the one piece of it that will challenge us through the rest of this year and 2017.

[Operator:]

That’s great. Thank you so much.

[Troy Clarke:]

You’re welcome.

[Operator:]

Our next question comes from Andy Casey with Wells Fargo.

[Andy Casey:]

Good morning. Thank you.

[Troy Clarke:]

Good morning, Andy.

[Andy Casey:]

I’m trying to understand it. I’m probably making a bigger point than needs to be on slide 15. You had some Canada dealer inventory down year-over-year, but it's up sequentially and that’s kind of consistent seasonally with what happened in the last few years. But as you pointed out, it kind of stands out against the industry weakness. Are you suggesting that you’re going to under-produce retail for the balance of the year? I'm just wondering what the – how we should kind of frame that as we think about 2017.

[Walter Borst:]

Under-produce retail, I think what were just saying is that we are seeing larger reductions in production than we’re seeing in retail unit estimates, as order share has been weaker for the industry and for us. So that’s in part why you’re seeing the dealer inventories coming down, but retail will be retail.

[Bill Kozek:]

I guess I would add, if you look at that inventory, you have to separate it out, medium, severe and heavy. And heavy, we have a little – we’re a little bit higher than our average. But in medium and severe, we’re in much better shape than the total industry

[Andy Casey:]

Okay. Thanks, Bill. And then, while we’re on kind of NAFTA, can you tell us what you're seeing in Class 8 pricing. The feedback from, at least our checks, is kind of competitive out there. Are you seeing that?

[Troy Clarke:]

For 31 years, Andy, I’ve seen it competitive, and especially today because everybody has capacity. And with heavy market down, everybody's going out through the same deals. It’s always going to be a competitive industry because there is capacity out there and it’s a very, very competitive industry. So I don't think it's any more competitive today than it was three or four years ago, but, yeah, that’s something that we’re going to live with really as long as we’re in the business.

[Andy Casey:]

Okay, thanks.

[Troy Clarke:]

And with the dealer inventories where they’re at, there's a lot of tactical initiatives in the marker to move the dealer inventory because eventually that turns into another order that we can build. That’s just an industry condition for all of us.

[Andy Casey:]

Okay, thank you. And then last one, the Parts margin, if I look at the first six months, it’s 27.1%. It’s a lot higher than what you did last year and you kind of called out some reasons. Should we expect that 27-ish margin to continue for the next six months or is there some reason to expect that'll relax a little bit?

[Bill Kozek:]

The margins improved due to aggressive cost management as well as the Fleetrite programs that we talked about and lean practices. So to expect us to continue to grow at 27% might be a little bit unrealistic, but we do expect our margin improvements to continue for the rest of this year and certainly out into the future.

[Andy Casey:]

Okay, thank you very much.

[Troy Clarke:]

You’re welcome.

[Operator:]

Our next question comes from Steven Fisher with UBS.

[Steven Fisher:]

Good morning. Just wondering what was the biggest surprise for you guys in the quarter because it seems like EBITDA was quite a bit better than your expectations. It sounds like it was at least partly costs, but if so what areas of costs were better than expected and, I guess, to what extent was it also kind of surprises in the Parts profitability?

[Walter Borst:]

Yeah. I think you hit on the right two themes. The cost side did extremely well in the second quarter. Each of our areas kind of did better than what we would have expected and I think that’s a testament to the lean activities and the focus on being more and more efficient here. And then parts put up another record and they’ve just had a very good level of performance here for a reasonably long time now and hats off to that organization for what they did. But to focus on the retail business, they really put up some strong numbers for the quarter. So not totally unexpected because these are the two areas where we have done extremely well, but we’re happy to report the news nevertheless.

[Bill Kozek:]

Our biggest surprise, Steven, is that the results weren’t better.

[Steven Fisher:]

Okay. I'll keep that in mind for the second half. I guess just one clarification on the $800 million of year-end manufacturing cash guidance. What does that contemplate for transfers from Financial Services operations? I know you mentioned the dividend that you had in the second quarter here.

[Walter Borst:]

Yeah. So over the second half of the year, I think it does anticipate some further pay-down of the used truck loan, similar to what we saw in Q2 by the end of the year and there may be – we’ll take a look and see whether we do any additional dividends from NFC, but we also have some loans outstanding to the parent, which could be paid down as part of that. So I’d consider that neutral. So, net-net, I would say there's probably more going to NFC than coming from NFC on a liquidity perspective due to the partial pay-down of the used truck loan that we have outstanding with NFC.

[Steven Fisher:]

Okay, great. Thanks.

[Troy Clarke:]

You’re welcome.

[Operator:]

Your next question comes from Seth Weber with RBC Capital Markets.

[Seth Weber:]

Hey, good morning, everybody.

[Troy Clarke:]

Good morning.

[Seth Weber:]

I guess for Walter, just first, a clarification, the $19 million of income, the deferred income from the IP license that you recognized in the quarter, what is that and is that going to continue here for the balance of the year or how do we think about that $19 million number?

[Walter Borst:]

Yeah. So that relates to our termination of production for CAT that was announced by them here recently, so there was some payments that they needed to make to us over time and we have – we were amortizing that over a few periods. We’ve accelerated that into Q2 with the termination of that production. So you should not expect that to continue going forward.

[Seth Weber:]

Okay, great. Thank you. And then, just going back to your prepared remarks, Walter, you said, you think the used truck inventory could be an overhang for the next couple of years. That sort of surprised me. Do you think the Navistar’s used truck inventory continues to move higher from here? I know you’re talking about just as an industry phenomenon, but how do you think this all plays out? Is it a gradual? Things get worse and then get better? Or is it just sort of – kind of stays elevated here for a while?

[Walter Borst:]

We’re going to try to work them down over time, so I’m not going to predict whether we’ve hit the high on used truck inventories yet, but as we’ve indicated the last couple of quarters, we’re trying to manage our receipts and look for additional opportunities to sell our used trucks, both domestically and abroad. But we have $448 million of gross inventory. That's too high and we need to work that down. But it’s going to take us a little while to work that down, probably a couple of years to kind of get back to levels that we prefer that to be at and that we would've seen historically. So that's really what that's referring to. I think what you’ve seen additionally over the last quarter or two is that our competitors are getting more used truck back as well and they need to place those into the market which has made the pricing environment for used trucks more competitive.

[Troy Clarke:]

I thought Walter's comments really related to the industry overhang where there’s a lot of trucks of all makes coming back to the market, which says two things. One is, as Walter indicated, it over-supplies the market with used trucks, which has an effect on price of used trucks in the market. And then that kind of doubles back on demand because you have a circumstance where the book value that a guy may be carrying the truck at is a little bit higher than the market value, and so then he just decides to hold on to the truck for another year. Trucks today are really good. They run better than they ever have, and so that's an option that's available to people. So kind of two sides of it. We have a unique circumstance that we really haven't changed our posture on how we’re working our way through it and I think Walter’s comments are really consistent with how we’ve treated that subject in the past. But there is, however, this kind of headwind, however you choose to characterize it in the industry, that’s just related to all-makes used trucks that are in the market and the market needs to absorb those used trucks. And that will be part of, I think, the recovery of the cycle eventually.

[Seth Weber:]

Sure. That makes sense. I think ACT called out used truck pricing down about 12% last month. Do you think that it gets worse from there or is that – do you feel like that that’s sort of…

[Bill Kozek:]

Who’s to say? But the used truck market is a very efficient market. I think it really does represent, I think, a look-forward value of those because these aren’t a surprise. The industry has a very good line of sight on what tends to come to the market from a used truck standpoint. So I think it's an efficient market and that's probably a very fair representation of pricing.

[Troy Clarke:]

I think, Bill, we’ve seen that through some firming in the last couple of months, haven’t we?

[Bill Kozek:]

Yeah. January and the winter is typically the worst time for used trucks, but there has been growth month over month and demand has improved in the used and there's been some stabilization in terms of pricing. But, again, like Troy said, it comes down to supply and demand in the used truck market.

[Seth Weber:]

Understood. Thanks very much, guys.

[Troy Clarke:]

Okay, Seth.

[Operator:]

Our next question comes from Adam Uhlman with Cleveland Research.

[Adam Uhlman:]

Hi, guys. Good morning.

[Troy Clarke:]

Hi, Adam.

[Adam Uhlman:]

Congrats on getting to the profit for the quarter. I think, Walter, you had mentioned earlier that commodities were a favorable cost element. I'm wondering if you could dimension just the magnitude of how much just the raw material savings you’ve been seeing. I know there’s been other product switching that’s happened, but steel’s been pretty volatile but it’s risen quite a bit. How do you see that unfolding for the second half of the year?

[Walter Borst:]

Yeah. It looks like there's kind of couple of questions in there, but maybe Persio wants to jump in here and tackle that a little bit.

[Persio Lisboa:]

Sure. Well, first of all, on the commodities side, we’re not breaking down overall performance. But on commodities, I think we are experiencing what the industry is now indicating that they are experiencing in terms of material costs, a reduction based on raw materials. So we’ve been taking advantage of that. We have our contracts that are – they allow to now be flexible with pricing. But we have some level of locks with the supply base that now make sure that we keep a very stable forecast ahead of us, which I think is the part that we’d like to talk about commodities. We don’t speculate with commodities. We just manage commodities. And I think we’ve been managing that fairly well. So, overall, I think there is – in addition to that, Adam, there's a lot of activity taking place with product cost reductions and design changes and improvements that we’re making. As we launch new products, though these launches are coming, they also open a very good window of opportunity for us to further improve the costs of our design. So that's another piece that you should take into consideration. It’s not just a status quo evolution from the products that we have today. It is really about the launches. That’s why I referred, we’ll have for the next two years, so every four to six months, we’re launching new products. Every time we do that, we’re going to take more cost out of our product. We’re getting more efficient in our design.

[Adam Uhlman:]

Okay, got you. And then just back to the other cost reduction initiatives for the second half of the year, back to Steve's question. I guess it’s unclear to me, are there further restructuring actions that are being contemplated or put into place versus more standard blocking and tackling to reduce costs against lower volume environment and any help in magnituding the – or dimensioning the magnitude of the savings would be helpful.

[Walter Borst:]

Yeah. We don’t have any restructuring actions yet because we’d have commented on those if we did. It’s more blocking and tackling. But in the more difficult industry environment we’re going to redouble, re-triple our efforts to look at additional opportunities. The biggest driver of additional cost reductions in the second half of the year will be from the procurement of the material side of the business as we continue to implement those design and product cost reduction action that Persio just referenced and it’s the largest cost driver. It’s the biggest portion of our costs. So we should anticipate the largest improvements there. So if we can continue to see the same level of performance that we saw in the first half of the year, that'll be the most significant driver of additional cost reductions over the balance of the year. On the structural cost side, we’ve done a very good job on SG&A. We are going to invest on some portions of the business around our telematics activities and OnCommand Connection. We do have some launches coming up that need to be supported from a marketing perspective. So we’re sure we don't want to take away from those opportunities.

[Adam Uhlman:]

Okay, thank you.

[Operator:]

Our next question comes from Neil Frohnapple with Longbow Research.

[Neil Frohnapple:]

As a follow-up to Seth’s question on the used market, any update on the population of the ProStars with MaxxForce engines that you guys still need to work through. I think you mentioned you were through, I think, 16,500 of the 30,000. So any update there and just any update on timing of when you’d expect to work through the remainder of the population given the incremental market softness?

[Walter Borst:]

Really no changes in terms of how we would expect that to run-up over the next couple of years. Obviously, as quarter goes by, the number of units that are no longer in the market continues to grow.

[Troy Clarke:]

The comments we’ve made in the past is there is roughly 60,000 units in the field. Typically, in normal circumstances, we would expect to work through – about one-third of those would come back. And the 16,000 number that we referenced last time would imply to you that we’re getting close to that. But it's not an exact number. It’s kind of deal by deal and circumstance by circumstance for us. So I think Walter’s earlier comment – this is something I think we end up working our way through over the next year and a half or so would be – is still valid.

[Neil Frohnapple:]

All right. That’s helpful, Troy. And then could you just talk about the decision to add the Cummins ISL 9-liter engine as an option for a few of those vehicles and obviously customer desire there and just how that impacts your capacity on the medium-duty engine side.

[Bill Kozek:]

Neil, it helps us enter an area that our customers have been asking for. They’ve been asking for us to include the Cummins 9-liter and that’s a piece of the medium market that we really haven't been in here for a few years. So if you look at that, the ISL is going to go in both the WorkStar, which is going to help us from a server service standpoint, and the DuraStar, which is going to help us from a medium standpoint. So, really, it was all around what the customers were asking us to put into our vehicle.

[Neil Frohnapple:]

Sure. Thanks for the color, Bill.

[Bill Kozek:]

Sure.

[Operator:]

Our next question comes from Kirk Ludtke with Cowen.

[Kirk Ludtke:]

Good morning, everyone.

[Troy Clarke:]

Good morning.

[Kirk Ludtke:]

For Walter, I guess, coming into the year, I think you were expecting about $600 million of cash requirements excluding working capital. And I'm just curious, has that number changed given the increase in the warranty reserve?

[Walter Borst:]

No, that’s a reasonably good estimate for what we would expect on the cash use side for the year. The warranty accruals that we booked this quarter will turn into cash over time, but most of that won’t hit this year. There may be some small portion that we see in 2016, but most of that will be in future periods. So I think that $600 million number is still a reasonably good estimate of our cash uses for the year. And when you kind of put that against our revised adjusted EBITDA guidance of $550 million to $600 million, that’s one of the reasons we’re cautioning about where we’d be free cash flow positive for the year.

[Kirk Ludtke:]

Right, got it. Thank you. And with respect to – if I’m doing the math correctly, it looks like between the first and the second half, sales will be up about $600 million based on the midpoint and adjusted EBITDA moving up about $50 million. That’s a contribution margin of less than 10%, which seems a little low. And I was curious if you see the numbers the same way? And if that is the contribution margin, is that something – is that a number or a range we should be using going forward?

[Walter Borst:]

Yeah. Well, revenue should be higher in the second half of the year versus the first half based on the revised guidance that we provided. We haven’t provided those margin estimates previously, but the 10% doesn’t sound like the right number to me.

[Kirk Ludtke:]

Right. Okay, that’s helpful. That’s all I have. Thank you.

[Operator:]

Our next question comes from Jerry Revich with Goldman Sachs.

[Jerry Revich:]

Hi. Good morning, everyone.

[Troy Clarke:]

Hi, Jerry.

[Jerry Revich:]

Troy, I’m wondering if you could talk about slide 16, the retail sales market share. Based on your guidance, can you just give us a rough sense of what should the retail market share look like for you folks for the July quarter or any sort of comments by the product categories that you've laid out here that you’re willing to provide would be helpful.

[Troy Clarke:]

Okay. So I just got the chart in front of me. So what would you like me to comment on?

[Jerry Revich:]

So you spoke about, you expect to gain share back half versus the first half and I’m wondering if you could just talk about the share targets that’s embedded in your guidance versus what you delivered in April quarter for the four categories. So which categories do you expect to drive your share gains sequentially and the order of magnitude?

[Troy Clarke:]

So I’ll just comment and then ask Bill to jump in. So kind of what we said was, there’ll continue to be pressure on our share on Class 8 heavy trucks. We’re well positioned with regards to Class 6 and 7 medium trucks and would anticipate continuing to make progress there. We’re better positioned with regards to our Class 8 severe service trucks, and so we’d anticipate continuing to make progress there. And I think the school bus market is still a good market for us going forward. Would you state that differently, Bill?

[Bill Kozek:]

Yeah. I guess, looking at where we are from an order intake standpoint, if you looked at that specifically, heavy, our order intake is up 2 percentage points year-over-year in heavy. In severe, we’re up about 4 percentage points and the HX is going to help that as well as the ISL. And then in the medium duty, if you remove the gasoline, we’re up year-over-year slightly to – the quarter was 27%, but our goal is in the 25%, 26% range. So that gives you a pretty good idea of where we think we are heading with the order intake higher than it was last year.

[Jerry Revich:]

And, Troy, you made some comments on the truck trade-in program. I think you implied that you're targeting 20,000 units of trade-in out of the 60,000. And last quarter, you mentioned you were at 16,500 at that point. So the run rate of trade-ins is coming down to about 600 per quarter from the 1500 to 2000 a quarter that you've been running. Are those pieces right?

[Troy Clarke:]

Yeah. So just to clarify, so don’t hold me exactly to the 20,000 because I said that directionally in a normal period of time. We’ll look at every circumstance, so we may be a little bit below, we may be a little bit above that when we finally kind of land this plane. The second thing – point that I would highlight to you is we don't look at it at a kind of a monthly run rate. We can go back and look at that data and have some further conversation if you think it would be helpful because it turns out to be fairly lumpy for us. What we do is we’ll get a deal, and if it’s a large deal, then we negotiate basically the rate at which we’re taking used truck trades kind of in conjunction with when we’re delivering new trucks, right? So there’s really not a lot of science, but there is a lot of effort placed into trying to manage basically the flow of trucks out, the flow of trucks in and processing them as well. So I think the thing that we’re – really, the takeaway point that we try to highlight is just the fact that we are trying to manage this with a great amount of attention. We need to lower the – we’ve got to get these trucks processed. We’ve got to lower them – we’ve got programs to do that. We’re looking at exports. We have a certified renewed program – certified used vehicle program called Diamond Renewed which continues to gain traction in the marketplace. We’re working hard to keep our dealers engaged and our dealers turn out to be one of the best outlets for us to sell these trucks, okay? And ultimately, I think we have a great proposition. On our Diamond Renewed, we put on OnCommand Connection on them and we’re starting to get a lot more traction because we can actually help manage the uptime of these used vehicles to a level that we think is oftentimes superior than what you might get on a standard use – on a standard truck in the marketplace. The more success we have on that side of the equation, then the more opportunity that we could actually lean into, either more trades faster or more trades over a longer period of time. So it’s something that we kind of manage quarter by quarter. We think we’re making the right kind of trade-offs. I would encourage you to keep asking questions. Again, we’re not trying to hide anything here. We’ll share more information with you. But it's kind of like – I wouldn’t be surprised if tomorrow the guys come in and say, we have a new idea for doing this, and then we look at that. So, quite frankly, I'm very impressed and proud of the team and how creative they’ve been to take the circumstance and actually make into something that I think is – will work out okay over time. Anyway, those are just some thoughts there. Again, we can follow-up more specifically with some math with you.

[Jerry Revich:]

I appreciate the color, Troy. And lastly, you folks had excellent performance in Blue Diamond parts, judging by the non-controlling interest disclosure. Can you just provide some more context on what's driving the growth and how you see back half versus first half for that part of the business?

[Bill Kozek:]

Yeah. We had 6% growth for the second quarter on Blue Diamond parts and it was a lot of execution. The team did a wonderful job growing that. We chartered them with continuing to grow that for the second half of this year and understanding that eventually the engines will run out. But that's an area that our team has spent a lot of time emphasizing and figuring out how we can grow the business in light of decreasing population over the long-term.

[Troy Clarke:]

This is a business that is – it’s a captive vehicle park and the pie is not growing, but the competition are – all the aftermarket mix of people and stuff. So a tremendous effort on the part of the team on tactical initiatives to basically get more sales for us and less sales for the third-party, aftermarket suppliers of those parts. It's really a terrific effort.

[Jerry Revich:]

Excellent. Thank you very much.

[Troy Clarke:]

Okay, I think we’re going to do one more question and then we’re going to call it quits. Those of you who have additional follow-up required, please feel free to call the IR group and we’ll line up something for later today or even later this week if it's more convenient. So one more question, operator, please.

[Operator:]

Our last question comes from Rob Wertheimer with Barclays.

[Rob Wertheimer:]

Hi. Good morning. Thanks for filling me in. Impressive results. A question on pricing. I’m not sure you really can say the pricing was all that dramatically weaker. It's always been tough, you mentioned. But is severe service better than line-haul? Is whatever issues there are confined to excess production in line-haul or is it both?

[Troy Clarke:]

I would say that in Class 8, and severe service is part of Class 8, it is challenged as well. With oil and gas down, and everybody knows the reasons for that, that piece of the market is challenged. So that piece, specifically, is down a little bit, and always competitive too. But if you look at the entire severe service, some of that is very, very specialized equipment and there is not as much pricing pressure in that specific segment. So it’s kind of two different markets or more than that actually. There’s a number of different markets in severe. But yes on some of it and no on some of the others.

[Rob Wertheimer:]

Perfect, thank you. And then I can ask on the parts strategy, is this a total increase in the parts profit pool, i.e. your dealers are increasing parts to customers supported by marketing or product improvement or whatever or is it more that you’ve managed to raise prices and we’ll see if it gets passed through to customers?

[Troy Clarke:]

No, I think it's total execution. I think we spend an enormous amount of time working on retail initiatives between us and our dealer channel. So it does us no good to just dump parts in our dealers without those going into retail channels because that ultimately is going to – we’re going to have to help out on that end of it. So, no, really, we spend an enormous amount of time on the execution of the retail piece of this. And our dealer body has done a wonderful job in terms of growing their share of the total market.

[Rob Wertheimer:]

Perfect, thank you.

[Troy Clarke:]

All right. Thank you. I don't have a lot of closing comments. Thank you so much for your participation today and listening to us and the story of our second quarter. I’ll just end by saying, I think we made some good progress in the quarter and there's more progress to come. We’re excited about our new products that are coming to the market. We think that some number of those could be game changers. Look, we’re facing some industry headwinds, which makes it just a little foggy to see too far ahead clearly. I'd be remiss if I didn't say, we feel very good about the momentum that we are building. Look, headwinds at some point in time will turn into tailwinds. When they do, we are extremely well-positioned with our current cost structure and the changes we’ve made in our company to really deliver shareholder value. Thank you very much again for your time on the call.

[Operator:]

Ladies and gentlemen, this does conclude today’s presentation. You may now disconnect and have a wonderful day.