Navistar International Corporation
Q1 2012 Earnings Call Transcript

Published: 8 Mar 2012

[Operator:]

Good morning, everyone, and welcome to the Navistar International Corporation First Quarter Earnings Release. Today's conference is being recorded. For opening remarks and introductions, I would like to turn the program over to Vice President of Investor Relations, Heather Kos. Ms. Kos, please go ahead.

[Heather Kos:]

Good morning. Before we begin, I'd like to cover a few items. A copy of this morning's press release and the presentation slides that we will be using today have been posted on our Investor Relations website for your reference. The financial results presented here are on a GAAP basis and, in some cases, on a non-GAAP basis. The non-GAAP financial measures discussed in the call are reconciled to the U.S. GAAP equivalent as part of the appendix in the slide deck. Finally, today's presentation includes some forward-looking statements about our expectations for future performance. 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 projected in today's presentation, please refer to our most recent reports on Form 10-K and 10-Q and our other SEC filings. We would also refer you to the forward-looking statements and other cautionary note disclaimers presented in today's material for more information on the subject. And now, I'll turn it over to Dan Ustian.

[Daniel C. Ustian:]

A.J., why don't you start us out with the agenda and talk through the first quarter results, please?

[Andrew J. Cederoth:]

Good morning. As you can tell today, we're taking a different approach to the call. Given the significance of the results, we're going to get right into the major pieces of the income walk. I'll walk you through the quarter and then turn it over to Dan to outline for you our plan to bounce back from this quarter and deliver full year earnings in a range that gets us close to $5 per share. Then I'll come back and update our cash position and discuss more about our focus on margin expansion. Included in the appendix are all the normal slides that we traditionally use so that you can reference those at your convenience. So let's get started. On Page 5, summarized here are the results of the quarter. In total, the loss was $2.08 per share. We've separated these into 2 columns because as you can tell, the impact of the warranty charge can overwhelm the results. Carving out the warranty and despite several operational issues that we discussed last month, segment profit was positive, offset by higher health care costs, resulting in a loss of $1.02 per share. As I said, the impact of the warranty charge was significant. We did record an adjustment to our accrual for engine warranty of $112 million, of which this is separated into 2 significant buckets. This is broken out for you on Page 6. It's important to remember that the accrual is an estimate of future payment. It's noncash and management actions can positively influence this accrual in the future. So what many of you may be asking is, how did we end up with such a large adjustment? As you may know, warranty reserves are intended to be estimates. We test these estimates at the end of each quarter for any material movement. We track the actual spending and compare this against projected spending to determine the adequacy of the reserve. The projected spending is based on frequency of repairs and cost per repair. What happened in Q1 isn't so much driven by the absolute increase in spending, but rather the deviation from the estimate. It's also important to note that these estimates are built around historical data, not anticipated future data. So let me give you an example, particularly as it relates to the 2010 engines. As we have refined the calibration of these engines and improved their performance, this has resulted in an unusually high frequency of repair on a couple of significant components. While our analysis supports that this is a spike and that this will correct itself in the future, the trend cannot be ignored. Thus, we have to acknowledge the higher frequency of repairs in our accrual. It's important to note that these calibrations have stabilized and we expect the frequency of repair to normalize over time. Thus, we believe there's an opportunity for some of this accrual to be reduced as we move forward. Also, we've taken action to reduce our cost for repair and implemented field actions that we believe will reduce future spending as well, but we cannot recognize these opportunities until such time as the data supports the change. Beyond warranty, the first quarter contained several other events that contributed to the loss. These are summarized on Page 7. We discussed health care at Analyst Day, but the impact to the quarter was $49 million, and for the year this is close to $200 million, which is approximately $90 million more than 2011. We discussed our strategy around reopening the Indianapolis foundry. This has allowed us to alleviate some capacity constraints around castings and to lower our costs. With that, we explained we would have some start-up costs in Q1. Additionally, MWM in Brazil experienced some production interruptions associated with weather issues in Asia. These issues disrupted the flow of components to a major customer, which ultimately impacted the flow of engines to the same customer. Coupled, these issues within engine had a $20-million impact but we expect to overcome these for the full year. We've already discussed that 2012 will be a year of lower military revenue, but equally impactful is the reduction of tactical wheeled vehicles within that revenue mix. We like what we have with our military business, because this is a business that even in down years is capable of generating 10% margin. Going back to Analyst Day, we talked about the start-up status of our businesses in India and Brazil. These both had an impact in the quarter but we expect that each business will improve as the year progresses. We did have a minor issue around engine supply for our global products. Recall, we purchased these engines but we believe we have this issue resolved and we should be fine for the full year. So we've had an eventful quarter. Some things we knew about; some things we didn't. With the exception of the warranty adjustment, these first quarter events should have a minor impact on our full year objectives. I'll let Dan take over now and put the remainder of 2012 in context.

[Daniel C. Ustian:]

Yes. Thanks, A.J. If you turn over to Slide 8, I think A.J. identified it properly. We're going to be a little more granular today about how we get to the objective of somewhere around $5 a share. So if you look at the bottom of Slide 8, you can see our guidance is $4.25 to $5.25. I do want to point out, that as A.J. pointed out, from last year to this year, there are 2 things that are different. Postretirement has increased by about $100 and the tax rate has increased as well. The total effect is about $2-a-share difference from a nonoperating basis, $2-a-share difference from year-to-year. So essentially, if we didn't have those, the $5.25 guidance would be $7.25 on an apples-to-apples basis from last year. But what we'd like to focus on now are 5 items, how we make the $4.25 to $5.25 guidance that we have. And A.J. has -- so they're listed on here

[Andrew J. Cederoth:]

Thanks, Dan. We talked back on Analyst Day on the importance of expanding our margins and improving our cash flow in order to sustain the investments that lead to our strategic success. This is where we have our businesses focused primarily on margin expansion and cash flow. So let's start with cash flow. We ended the quarter with manufacturing cash of $837 million. As you may recall, we had to stop shipping trucks late in the quarter. This caused us to end the quarter with slightly more inventory than we expected, but we've resolved these issues and trucks are now flowing normally. For the full year, not much has changed. We recognize that there's been some adjustments to cash from operations. But like warranty, most of these are noncash items. Similar to income, however, the cash will remain relatively flat through the first couple of quarters and then recover in the second half of the year. To improve upon our cash flow, we continue our efforts to reduce the level of working capital we deploy in our business. While not yet developed well enough to incorporate into an official forecast, we have challenged each business to reduce their working capital needs, which would enable us to close the year with a cash balance beyond $1.2 billion. To close, I'd like to build upon Dan's discussion on margins, particularly our efforts to expand on these margins. As we've stated, our strategic plan is to expand our business to $20 billion of revenue. And when we do this, generate 1 point billion dollars (sic) [$1.8 billion] of segment profit for a blended return on sales of 9%. We've organized the chart on Page 25 to show the path that each of our businesses is on to achieve our strategy. You can see here that we've incorporated service parts into the businesses because as we grow our truck and engine businesses, we create the opportunity to expand our parts business. We believe we have the business on the right path. When we normalize 2012 and look at the run rate of the business by the end of the year, you can see the results. Throughout this presentation, Dan's focus has been on the elements of the business that lead to strategic success and improve our margins. From our focus on integration and streamlining our organization by leveraging this new building; to expanding into new markets like natural gas and further leveraging the opportunities within our defense business; and finally, and I believe most importantly, by expanding our product offering, both domestically and globally, to get closer to the customer and to continue to expand our margin. I believe these are the differentiators that we have and that these will drive success in our business and ultimately lead to strategic success. With that, Heather, I think we're ready to field questions.

[Heather Kos:]

Operator, we're ready for questions.

[Operator:]

[Operator Instructions] And we'll hear first from Andy Casey with Wells Fargo Securities.

[Andrew M. Casey:]

First, thanks for the clarification on the $25-million NCP hit. Dan, could you -- or, A.J., let us know how many months you're assuming the NCP payments continue for that $25-million hit?

[Daniel C. Ustian:]

Yes. So, Andy, here's a -- maybe a way to look at it. We've submitted the -- for the 0.2. And that goes through a process and typically that's about 3 months, I think, is about the average of that. So when we get the certification, it still takes some time for us to get to production on this. So what we're doing right now is getting ready to go to production in that, and it will be about June before we can get into production with that particular engine. So that -- it kind of gives you a framework of where it would be. The preciseness of it, we can't tell you, but our objective is to begin production on that in June.

[Andrew M. Casey:]

Okay. And then if we look at these warranty issues that caused the charges, can you kind of give us a little more detail, so we can make an assessment on why these may or may not impact field performance of your ultimate solution for EPA 2010 at the 0.2 level?

[Daniel C. Ustian:]

Yes, yes. First, let's break it into 2 categories. I think the first one is those are -- the half of it is from old products. And those are things that we had assumed we had repaired. We had all those fixes in place and -- but the trends didn't come down like we had expected. So obviously, we didn't fix them to the level that satisfied our trend rate, and so that continues. The other ones were -- we went out in the field and were more proactive on it and it increased our trend rate because of that. And what we need to do now is to prove that those fixes are in place and that trend rate will come down, both from a -- as A.J. points out, from a frequency standpoint and from a dollar standpoint. So we believe they're all in place. These are from '10 -- early '10 products. We had an opportunity when we found that our customers, their utilization of their vehicles are less in the December month, so we went after them with aggressiveness to try to get at them during periods when they wouldn't be running as much. And we did that, but what it did do was increase the trend rate on that. So that also gives us the confidence that we can bring it down again.

[Operator:]

And we'll continue onto David Leiker with Robert W. Baird.

[David Leiker:]

Dan, did you say the actual cash cost to execute these warranty changes in the quarter, that was the $3-million number? Did I hear that correctly?

[Daniel C. Ustian:]

Yes.

[Andrew J. Cederoth:]

David, it was a $3-million increase from what we expected.

[Daniel C. Ustian:]

Increase from the trend that we had before.

[David Leiker:]

Okay. And then if...

[Daniel C. Ustian:]

Someone just slipped me a note here and these -- we've got all of the Vs and the inline DTs and we haven't had any issues since the '06 and '08 one I just talked about there. So these '10 engines are running the best they've ever run. It's that in the early on '10, there were some minor things that caused us to go back and repair them, and much of them were in calibration.

[David Leiker:]

Great. And then can you detail specifically what components, what parts of the engines that you're having a warranty issue with on those engines?

[Daniel C. Ustian:]

I think when you get into these things, everything is so electronically controlled that when you do a calibration on it, it could affect whether the performance of any part of that engine works or not. And when you have, how many different -- I've got Jack Allen here. We have so many different variations that the electronic controls have to be able to adapt to each one of those. And we had -- we took some time, several months, before we got all those things in place on the control side. So it's more of a system thing, I think, Dave, than it is a part thing.

[Jack J. Allen:]

Not specific hardware.

[David Leiker:]

Right. Not specific hardware, right.

[David Leiker:]

Okay. And if you go over the next several months or so and you wait for this -- the cost trend to start to improve from these actions, what's the timeline on the other, as to being able to see that? Are those weeks? Are those months? Quarters? How would you characterize that?

[Daniel C. Ustian:]

Let me -- so we understand what it is. So the ones going out the door for the last year, that -- those are done [indiscernible] we're talking about the ones that are already out there. So what's accounting does -- and I'll ask A.J. to chime in here, but I've had enough study of this. It's not like I don't know. And that is -- the accounting has to have the experience on the frequency of repair and the cost of those repairs. You have to prove it before you can bring this back out again. And we think it will take us until -- certainly won't happen in the second quarter. I think that's no question about that. It's going to be in the third or fourth quarter before we're able to get that back.

[David Leiker:]

Okay, great. That's exactly what I was looking for. And then one last item. If you hadn't seen that boost in the warranty reserve, it looks like you would have been in a position potentially to have raised your guidance. Is that the right way to look at that or not?

[Daniel C. Ustian:]

We probably wouldn't have. But I would say, we wouldn't do that. We wouldn't have done that, Dave. I think we would keep it at the same level that we're at right now. And I understand your question. I think it's probably appropriate that we've found ways to overcome some of those things out there, but we wouldn't have raised our guidance.

[Operator:]

We'll take our next question from Jerry Revich with Goldman Sachs.

[Jerry Revich:]

I'm wondering if you could talk about the comment you made in the Q about material cost outpacing pricing in the truck business in the first quarter, and just help us get a sense for when pricing is going to meet or exceed material inflation over the balance of the year. How does your contracted pricing and product out the door look from here?

[Daniel C. Ustian:]

I'm going to ask Jack here, but just to frame it now what that means, Jerry. That means that -- remember last year, we had pricing before we had the commodity increases because we had those hedges on it. Now the hedges are off or less and so the commodity costs are going up. So, Jack?

[Jack J. Allen:]

I mean the best way, I think, to describe it is, we have escalators with many of our customers relative to material costs, but they have lags built in with them. And now as commodities costs are hitting us relative to a year ago, as Dan said, primarily because we don't have the hedges. There's just a natural lag before we collect that in the marketplace on pricing. But we certainly have built into our plan, to catch-up on that as the year progresses.

[Daniel C. Ustian:]

So I think somewhere, maybe we have it in the package. I think we have that it has -- it's really stabilized for the last several months now and our fuel is up a little bit now. But commodities have stabilized now for several months.

[Jerry Revich:]

And so as you look at your remaining hedge book and your pricing schedule to customers on a year-over-year basis, Jack, when do you expect pricing to exceed material inflation? Which quarter or -- would you just give us a rough sense?

[Daniel C. Ustian:]

Well, I think, Jerry, the way Jack described it is the best way to look at it, is that pricing will escalate throughout the year. There's never a perfect match between material cost movement and hedge movement and pricing action. So our plans are to recover that in the second half of the year.

[Jerry Revich:]

Okay. And, Archie, if you're on the line, can you comment on the timing of the rolling chassis program? When is it looking like you'll get to work on those products? And also touch on the softer parts sales in the quarter. Anything timing-related that drove the significant decline?

[Archie Massicotte:]

Yes, Jerry. We're in production on the rolling chassis as we speak. We've already made our first delivery. We just acquired a contract to do the retrofitting of the body on the chassis at West Point. That contract was just over the wall as of last week. So that's ongoing and as you know, that's got a leg to it to go into 2014 -- or '13, rather. The parts side of the house, we're actually seeing an incline right now on parts sales. It is more so related to some of the earlier trucks that we had out in the field in Afghanistan and Iraq. And there's some new stuff going and I don't have the full order yet, but it's showing positive impact. Again, on the sustainment of everything we put in the field is really holding up well. And that business, as you know, we've turned completely over to the sustainment side. And that's starting to show pretty good results.

[Operator:]

We'll take our next question from Ann Duignan with JPMorgan.

[Ann P. Duignan:]

Can you talk a little bit about the impact of these higher warranties on residual values for your used trucks? And then secondly, could you talk a little bit about 15-liter to 13-liter? You've only submitted a 13-liter for approval to the EPA. Does that mean you're giving up on the 15-liter? And we look at Cummins in the last couple of months and it's gaining share, engine share, suggesting that customers are still specifying 15-liter engines out there. So sorry for the lengthy question, but if you could just kind of hook the 2 of those together, I'd appreciate it.

[Daniel C. Ustian:]

Sure. And I'll ask Jack to answer those. Go ahead, Jack.

[Jack J. Allen:]

Maybe one at a time. Used trucks clearly -- our ProStar continues to have excellent used truck residual values. The issues that we have described here, we're addressing them with the customers and we're addressing them in the deals. And therefore, there's really no impact to used trucks or calibration. We're fixing the calibration on them. We continue to see excellent used truck values. Regarding the submission, I think, was your second question. We submitted the 13-liter. We're prepared to submit the 11 and 15, Ann. I'm not quite sure why you would jump to the conclusion that we're abandoning it, but we're prepared to submit the 11 and 15. But it really doesn't make a lot of sense to do that until the EPA addresses the 13-liter and we can work back and forth with them, and then we'll follow on with the 11 and 15-liter. I'm sure you see the trend reports like we do. In 2011, 13-liter has crossed the threshold, 15-liters, and there's now more 13-liters sold in the marketplace today. And we believe that as one of our major competitors has a more free supply of their own proprietary engines in 2012, you'll continue to see the trend of 13-liters grow in the marketplace.

[Ann P. Duignan:]

So you have no comment on the fact that Cummins' 15-liter is gaining share in places like Freightliner and Volvo?

[Jack J. Allen:]

I think you got to just go back to the comment that I just made.

[Daniel C. Ustian:]

Ann, I think he's saying that there's some capacity constraints with some of our competitors on their own 15-liter and 13-liter right now.

[Operator:]

We'll take our next question from J. B. Groh with D.A. Davidson.

[J. B. Groh:]

I think this maybe plays a little bit on Ann's question on share. But can you -- on Slide 27, I noticed a little bit -- market share down a little bit. And I'm guessing that there's an impact from maybe some delays on the shipments in Q1. Can you sort of -- is there a way to quantify or maybe just give us an indication of why that's down and where you think it's going?

[Jack J. Allen:]

Well, salvage certainly is the Bendix shipment [ph] related at the end of the quarter. But in medium-duty, we had a big run-up the last half of the fiscal year last year, where we were trending way above 40%, which is above what our norm is. And that was driven by some big fleet sales as well as our fiscal year end, and we had some fewer year-end programs. So it wasn't really totally expected for us to see that fall off as the year began because competitors had their own year ends in December. So a number of things happened in the quarter. We replenished the stock inventory in our dealerships, so that hasn't rolled through to retail market share. Some fleet build that we traditionally would have had in the quarter has moved out to the second quarter and then a little bit of the Bendix issue. But just to give you one bit of data here, as we look at February. So it's not in the quarter but we have the information for February. On medium-duty, our retail deliveries in February for medium were 31% higher than our average monthly rate in the first quarter. So we're seeing the recovery that we had expected.

[J. B. Groh:]

So you got a combination of a little bit of a tough comp from last year and then some of the stuff that we mentioned about the delays?

[Jack J. Allen:]

Yes.

[J. B. Groh:]

Okay, okay. And then can you talk about maybe driver shortage and how that's -- you think that will impact customers? It's kind of an interesting dynamic.

[Jack J. Allen:]

Well, it is pretty amazing that in this era of unemployment that driver shortage has continued to plague our customers. But we spent a number of days with them this past weekend at the Truckload Carrier Conference. We talked a lot about drivers. I think the biggest thing you're going to see here and that they're seeing is that driver pay is progressing. And they're willing to pay drivers for productivity and drivers that are doing a good job for them. So we'll continue to see driver pay increase. And frankly, fleets are -- they're pressuring us around driver amenities and appeal and uptime for the drivers, so they can be profitable [ph].

[Operator:]

We'll hear now from Patrick Nolan with Deutsche Bank.

[Patrick Nolan:]

Just a couple of follow-up questions on the warranty and then a question on military. So just so I interpret it right, so you are factoring in that you do get $50 million to $60 million of this warranty charge back in the back half of the year. That's incorporated into the full year guidance.

[Andrew J. Cederoth:]

Yes, that's correct.

[Patrick Nolan:]

And so it sounds like most of these warranty issues are all engine calibrations. I mean, is it reasonable to assume that as you launch out the 0.2 engine, that there's potential for this to reoccur?

[Daniel C. Ustian:]

Well, I think that's a good question, Pat. This is why we're taking until June to go to production with it, so that won't happen. But I think that's a fair question, and we're doing the actions to prevent that from happening.

[Patrick Nolan:]

And just on those early 2010 engines, I mean, what's the average mileage of those engines that are out in the field now? Because I mean, I would assume a lot of the Advanced EGR concerns that people have would be when you're at the higher end of mileage for engines as far as additional heat and the impacts of that.

[Daniel C. Ustian:]

The early ones probably have a couple of hundred thousand miles on it. The things we're talking about are really kind of input things, so not mileage-related. That's probably the ones that are very early, there's a couple of hundred thousand miles on it.

[Patrick Nolan:]

Got it. And could you give us some color on what the cadence of military revenue is going to be for the remainder of the year?

[Daniel C. Ustian:]

Yes. I think, it's going to -- we said it's $250 million. I think the question earlier was -- so it was about $250 million in the first quarter. And I was anticipating and I think we'll be probably be a little higher in the second quarter. Archie, what [indiscernible]...

[Archie Massicotte:]

Well, the revenue -- as you know, we have a schedule for rolling chassis that are going through the system. And we are kind of regulated, by schedule, how many we can produce per month. I mean, there's a flow that has to be consistent with what they can take and so that's governing a little bit of what our revenues look like. But for guidance, for the year, I mean we're still marching towards the $1-billion to $1.5-billion range of guidance for military. Now how that comes in quarter-over-quarter, it again -- it will be more heavily loaded in the fourth quarter but that's just the way the business is.

[Andrew J. Cederoth:]

I think -- Pat, this is A.J. I think the -- when we look at that, I think military revenue was lower in the first quarter this year versus last year, and it will be lower in the second quarter versus last year as well.

[Daniel C. Ustian:]

But we said the whole year is going to be less.

[Andrew J. Cederoth:]

Right. Around $1.5 billion.

[Operator:]

Tim Denoyer with Wolfe Trahan.

[Timothy J. Denoyer:]

Quick question on the -- actually this is a follow-up on the military guidance. I thought that you had said $1.5 billion for the year. I thought -- was that new, the -- what Archie had just said, in terms of $1 billion to $1.5 billion?

[Daniel C. Ustian:]

No, our guidance is based on $1.5 billion of military revenue.

[Timothy J. Denoyer:]

Okay. And then another question just sort of on the medium duty market overall. You said things are picking up there, but just looking at the order trends over the last couple of months, it seems like medium duty has sort of taking a little bit of a step back. Are you seeing that in terms of your order trend in terms of heavy duty maybe outperforming medium right now?

[Jack J. Allen:]

Well, certainly the growth rate in heavy on a year-over-year basis is more than medium. But medium-duty market has some really -- some good increases also. But medium-duty market today is really heavily influenced by some large fleets and primarily it's on the leasing side. But -- so that medium tends to be more choppy from an order received rate and even from a share standpoint. In the first quarter, there was 16,000 deliveries. So 1% market share swing happens over 150, 160 trucks. You'll see a lot more choppiness in medium duty.

[Timothy J. Denoyer:]

And then one other question, on natural gas actually. With one of the slides that you showed in the sort of cost-benefit economics, do you imply that the customers would be getting sort of locked-in CNG prices over a multiyear period with Clean Energy?

[Daniel C. Ustian:]

I'm going to ask Eric Tech. He's in charge of our engine business. Eric?

[Eric Tech:]

Yes. That's one of the potential. There's a lot of different ways our customers can benefit this -- from this. They can stabilize their fuel costs over several years, they can lock in to the Clean Energy program or they can just play on the spread between the 2. So we're looking at developing the right solutions for our customers depending on what fleets we're selling to and depending on their circumstances. But clearly there's a huge spread there and an opportunity for them to reduce their operating costs.

[Timothy J. Denoyer:]

Yes. And at what point do you expect to introduce your own engine into the natural gas market? Was that '13 or '14?

[Eric Tech:]

We are currently producing a DT engine for medium trucks. And we're looking right now at introduction of a big bore engine sometime in the next 1.5 years.

[Timothy J. Denoyer:]

Okay. Is the DT at any significant numbers in terms of CNG?

[Eric Tech:]

Yes. Right now, we're really -- we're in the 100s and we see a large ramp-up as really we see now the interest that we've garnered on this natural gas play. And we really see the numbers ramping up through the end of this year. And really -- probably the impact will be more real in the next year than 2013.

[Operator:]

We will continue on to Andrew Kaplowitz with Barclays Capital.

[Vlad Bystricky:]

This is Vlad Bystricky on for Andy. First question. Can you just talk about, on the warranty issue in the quarter, how is that impacting your dealers? Is it an additional cost or additional work for them? And is that taking away at all from some of the training that you had talked about at your Analyst Day, related to rolling out more of your own engines?

[Daniel C. Ustian:]

Jack, go ahead. Why don't you answer that?

[Jack J. Allen:]

Well, the dealers have worked together with us and the customers in a partnership here to address the actions primarily that we took over Christmas. That's really the big driver here that we're talking about on this morning's call. So during this period of time, the customers would typically -- their vehicle utilization is down over those holidays and also, the dealerships have more availability during that period of time. So together -- we put our resources within the company together with the dealers and customers to address the customer concerns in that period of time. It worked out very well from a customer satisfaction and an upside standpoint.

[Vlad Bystricky:]

Okay, great. And then just thinking about your customers. We talked about the driver shortage and impact of rising driver wages. Can you talk about gas prices? Obviously, we've seen an increase there, and what are your customers saying about that? When does that start to be a concern for them? Are they able to pass on those prices now? Or when might it affect their buying decisions?

[Jack J. Allen:]

I think it's -- a lot of that depends on different segments of the business. I'll take it, if you're really focused on Class 8 here, most of the large fleets today and the shippers have a formula that they've used for some period of time now called fuel surcharge. And it allows the fleets to vary their rates to the customers on an ongoing basis, very variable, depending on what fuel prices are at the time the load is delivered. So it's a -- rising fuel prices are never a good thing for our industry. But at the same time, our customers have a mechanism under which to recover that. But at the end, it really does focus back on us. And the more we can do to provide a great fuel-efficient truck and engine, integrated solution, that's what our customers are looking to us for.

[Operator:]

We'll take our next question from Seth Weber with RBC Capital Markets.

[Seth Weber:]

Just wanted to go back to the accrual adjustment for a second. The 45% attached to the '06, '08 time frame, was that the same adjustment that you took in the second quarter of last year for the same -- is that the right way to think about it?

[Andrew J. Cederoth:]

Yes, it is, Seth. As Dan said, when we put that adjustment in last year, we thought we had the right trend and we expected that to perform according to that forecast and it's continued longer than we expected.

[Seth Weber:]

Okay. And if I remember, that was basically an injector problem or something like that. Is that correct?

[Andrew J. Cederoth:]

Right.

[Daniel C. Ustian:]

That's correct.

[Andrew J. Cederoth:]

Mostly related around medium-duty engines.

[Seth Weber:]

Okay. And then just a clarification on the outgoing run rate margin targets that you put up. So for the engine business, the 7 to 8. So that includes the $50-million to $60-million add-back for the accrual, then?

[Andrew J. Cederoth:]

Yes, we've -- I mean we've taken the accrual adjustment out of that, so that we can look at the business on a run rate basis.

[Seth Weber:]

Sorry. So just -- that does not include the add-back at the end of the year that you expect?

[Daniel C. Ustian:]

Well, no, no.

[Andrew J. Cederoth:]

No. It doesn't include the add-back. It doesn't -- also, it doesn't include the charge. We're kind of viewing the charge for warranty as a onetime item.

[Operator:]

And Robert Wertheimer with Vertical Research Partners.

[Robert Wertheimer:]

I'm still trying to figure out how to isolate or evaluate the 15-liter side. And I'm wondering if you could say if the issues were specific to a particular production run or a particular production date or engines that underwent a particular calibration. You mentioned you went out to customers with a fix. And I don't know whether -- how you identified those trucks that you went out to, those engines that you went out to, and whether you've gone out to all the ones you've identified yet.

[Daniel C. Ustian:]

So that's sort of the early 13-liter, I don't -- if we said 15-liters, we didn't mean...

[Robert Wertheimer:]

I'm sorry. That was my fault. I beg your pardon.

[Daniel C. Ustian:]

Okay. So these were early 13-liter vintage that we went out and did some calibration to get these different -- various different repairs [ph], sometimes in signal, sometimes in operations. We went out there and tried to get at most of those or all of those during the holiday period here.

[Robert Wertheimer:]

So the final calibration...

[Daniel C. Ustian:]

The production side of that is in place and it has been in place for quite some time now.

[Robert Wertheimer:]

Okay. So the final calibration, you're pretty confident, is not causing issues. It was an interim calibration that caused an issue with component failure. I'm just trying to understand that part.

[Jack J. Allen:]

It was the calibration that was in effect at the time those vehicles were built back in 2010. We subsequently updated those vehicles with current production calibrations and that's alleviated the issues that were present at that time.

[Robert Wertheimer:]

Okay. And so you have not seen any issues with trucks that were shipped under the final production of the current calibration.

[Jack J. Allen:]

The vehicles that we're putting in the marketplace right now are performing to our expectations.

[Robert Wertheimer:]

Okay. And then just one quick question, A.J. It was a little surprising to see this issue pop up after you have listed the few issues that could have affected the quarter, and this wasn't on it. I assume it's because that $3-million ramp over trend was just something you hadn't spotted as of February 1. Is that why it came in after the quarter?

[Andrew J. Cederoth:]

It came in after the quarter because it does take us a little bit of time and it takes a lot of analytics to truly understand the real impact of this type of an adjustment. And we didn't have that information clearly understood on Analyst Day.

[Operator:]

And, ladies and gentlemen, that's all the time we have for questions today. I'll turn things back over to our speakers for any additional or closing remarks.

[Daniel C. Ustian:]

Okay, thank you. Of course, Heather and Randy will ask any questions -- answer any more questions that anyone might have, and we'll get back with you if you have any further questions. But thanks for joining us here this morning.

[Operator:]

Thank you. Ladies and gentlemen, that does conclude today's conference. Thank you for your participation.