Navistar International Corporation
Q2 2013 Earnings Call Transcript

Published: 11 Jun 2013

[Operator:]

Good day, and welcome, everyone, to the Navistar Second Quarter 2013 Earnings Results Conference Call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the program over to the Vice President of Investor Relations, Heather Kos. Please go ahead.

[Heather Kos:]

Good afternoon, everyone, and thank you for joining us for Navistar's second quarter 2013 conference call. With me today are Troy Clarke, our President and Chief Executive Officer; Jack Allen, our Executive Vice President and Chief Operating Officer; and A.J. Cederoth, our Chief Financial Officer. Before we begin, I'd like to cover a few items. A copy of the press release and the presentation slides that we will be using today have been posted on our Investor Relations website for your reference. The non-GAAP financial measures discussed in this 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 Safe Harbor statement and Other Cautionary Notes disclaimer presented in today's material for more information on the subject. With that, I'll turn the call over to Troy Clarke for his opening remarks.

[Troy A. Clarke:]

Okay. Hey, thanks, Heather, and good afternoon, everyone, and thank you for joining our call. Hey, I recognize the call is later than we would like or normally do for this quarter. We had to take some time to work out an accounting issue that we wanted to make sure that we got right, and A.J. will give you some more color on that in his comments. But for my part, I would like to apologize to all of you for any inconvenience we may have created in your schedules. And in addition to that, to assure you that we'll work back to our regularly scheduled time when you might expect it at the end of our next quarter. Our agenda today will follow the same process we've established several quarters ago. I'm going to lead off with a high-level overview of our second quarter performance and our progress in our strategic objectives. A.J. will provide a deeper dive on the financial results; and Jack Allen, our new Chief Operating Officer, will discuss the latest warranty and quality developments, as well as provide more specific direction regarding our second half sales and share initiatives. And then I'm going to wrap up with some closing remarks on long-term EBITDA goals, and that will lead into then Q&A. Before I begin, however, I just want to reiterate how pleased I am to have Jack joining me on the call as our COO. Many of you know him from past earnings calls and some of you have even met with him in person. As I have worked with Jack, I found him to be a results-focused and industry-savvy leader, the right leader to strengthen our North America core business. And you're going to hear directly from him in a few minutes. Turning to Slide 6. You will notice that this is the same roadmap we have been using since we embarked upon our turnaround last August. The point I would make, there is no change to our strategy or our guiding principles since we introduced this back in Q3 of 2012. We have a solid plan. One we've consistently said will take us 12 to 18 months to execute. I believe this quarter's performance reflects continued progress on our near-term priorities, while pointing out that we still face a few significant yet solvable challenges. So regarding our results, let's get right to it. Positives for the quarter include

[Andrew J. Cederoth:]

Thank you, Troy, and good afternoon, everyone. Turning to Page 9, are the results for the quarter. Revenue for the quarter was $2.5 billion, down $735 million or 23% from 2012. The primary driver of this was lower overall industry demand, which was down 14% year-over-year. Lower industry combined with market share decline resulted in lower overall shipments for North America of 6,900 units versus 2012. For the quarter, loss from continuing operations was $353 million, which is $215 million worse than 2012. Here, again, I think the impact of the volume and the warranty are overshadowing some very positive changes in our business. Turning to Page 10. Here, we are showing what has changed in our business. And while the results of the quarter are not satisfactory, several positive trends are developing in our business. Structural costs, primarily SG&A and engineering spending, are $81 million lower than last year. Material costs and manufacturing efficiencies have improved year-over-year by $25 million. Service parts margins have improved by $22 million. And our focus on return on investment has improved the bottom line by $53 million. As I mentioned before, the overall industry was lower by 14%. During the engine transition, our market share has also suffered. As we complete the product changeover to SCR, we expect our market share to recover. But year-over-year, industry, market share and mix had a negative impact on the business of $109 million. As we all know, we continue to experience higher warranty costs. Finally, the year-over-year results are skewed by the release of the Canadian tax valuation allowance that occurred last year, resulting in a $181 million onetime gain that ran through the tax line. Turning to Page 11. Let me spend a moment on the warranty charge. As we discussed on our December call, given the level of expense we recorded in 2012, we expect that cash spending on warranty repairs to be higher in 2013. This was factored into our planning and our cash forecast. As Troy alluded to earlier, we are now starting to receive more end-of-life data on the initial builds of 2010 emissions vehicles, and we've experienced an increased level of repair activity driven by our field campaigns. It's important to understand that even though the actual data from the field is driven by a limited population, it has a large influence on the estimated liability for the entire population, until such time that we have sufficient data to support that the design changes implemented into production have effectively reduced the frequency and cost of repairs. Jack will share with you later that our build quality continues to improve quarter-over-quarter, and we believe a significant number of these field repairs are corrected in later builds. But given the data that we have, we believe it's appropriate to increase the warranty reserve related to pre-existing vehicles by $164 million. On Page 12, we've reconciled our actual ending cash -- manufacturing cash against the forecast we provided on our last call. We ended the quarter with manufacturing cash of $1.164 billion, which exceeded the high end of our guidance. As we discussed, corporate EBITDA was adversely impacted by volume and warranty. On this page, we've isolated the warranty true-up for vehicles in the field that I previously mentioned to illustrate the EBITDA result of the business net of the warranty impact. We did have an out-of-period adjustment in the quarter to correct revenue recognition on certain sales that were financed by GE Capital. This is further outlined in our 10-Q. The net income impact of this adjustment is immaterial to the bottom line and does not impact cash, but it does impact EBITDA favorably for the quarter by approximately $62 million. This should be viewed as a onetime adjustment. From the range we provided on our previous call, EBITDA, on a comparable basis, came in closer to the low end of the range. The reason for this was primarily lower volumes. Chargeout volumes for the quarter were slightly below our internal goal. We expect to recover these sales in May and June. Capital spending was lower than our guidance as we are closely managing investments during this transition period. An example of this was the deferral of the second investment of our China project until May. Finally, as we've discussed before, working capital management has improved and those actions continue to have a positive impact on cash flow. Turning to Page 13. Here, we are providing our cash outlook for the third quarter. Recall, the third quarter is typically a challenging cash flow quarter for our business due to the traditional summer shutdowns. We expect cash at the end of the third quarter to range between $1 billion and $1.1 billion. I expect EBITDA to improve in Q3, primarily driven by volume. Through the first half of the fiscal year, there has been a significant amount of noise running through the P&L. We have taken action to improve the business and to eliminate issues that have been a drag on earnings, most of this is behind us now. We expect Q3 to be the quarter that we begin to demonstrate improved core business performance, thus we expect to generate positive EBITDA during the quarter. While we anticipate EBITDA to improve, it will still fall below the fixed charges for the quarter, primarily interest and pension, as these cash flows are seasonally higher in Q3 versus Q2. We are judiciously managing capital spending, but I anticipate an uptick in spending as we invest in programs that drive our cost reduction targets for 2014. And as I mentioned before, we made the second investment into our China project during Q3. Production volumes will increase in the quarter. Our forecast is built around the assumption that the overall market will strengthen during Q3 and our market share should begin to gradually recover. Thus, volume will grow and working capital will continue to have a positive impact. As I mentioned earlier, I am forecasting cash payments for warranty to exceed expense. This will manifest itself through working capital. We continue to remain confident with our overall liquidity position. We are carrying a large cash balance in order to demonstrate to all of our constituents, vendors, customers and shareholders, that we have adequate liquidity to support our turnaround strategy. In addition to our existing cash, we continue to have additional liquidity available from NFC. So in conclusion, the second quarter presented some challenges. While we are not satisfied with the results this quarter, I believe we are taking action to put the company on a better path going forward. We are carefully managing our spending while taking action to satisfy our customers. We are ahead of our goal on structural cost reductions. We have launched the 13-liter engine with SCR, and we expanded the number of vehicles that offer the Cummins ISX engine. From here, we expect volume to expand and our results to improve. I will stop here and let Jack put more details around the actions we are taking to drive continuous improvement in our business. Jack?

[John J. Allen:]

Thank you, A.J., and good afternoon, everyone. This is my first time joining you as Navistar's Chief Operating Officer, and I've gotten to know many of you over the years through my previous positions with the company, and I look forward to working with you in my new role. Let me kick off my portion of today's remarks with a little more color on the leadership change Troy mentioned. We're enhancing our organizational capabilities, and we're thrilled that Bill Kozek is joining Navistar as President of our North America Truck and Parts business, the job I held prior to being COO. Bill joined us from PACCAR, where he most recently headed up Peterbilt and before that held a similar position with Kenworth. His insights and perspectives on the industry and customers will help us improve the business, and that's really critical to our turnaround. So turning to Slide 16. Today, I'll focus on the 3 key elements of our Drive to Deliver plan

[Troy A. Clarke:]

Hey, thanks, Jack. As we stated, 2013 is a pivotal year. It's really our turnaround year. And when we launched our Drive to Deliver plan, we said we're going to do whatever it takes to turn our business around. And for us, that means targeting an EBITDA run rate in the 8% to 10% range by the end of 2015. We have more to do, but this is the right target. We are excited about the progress we're making. So let me elaborate a little bit by laying out the major building blocks you'll see towards this goal. First, our vision is not based on a large market recovery. We believe the market will improve, but we need to be more profitable in our core businesses at times in the cyle like today. To get to our EBITDA goal, we see the ability to make additional progress in the following areas

[Heather Kos:]

That concludes our prepared remarks. [Operator Instructions] So operator, we're ready to open the line.

[Operator:]

[Operator Instructions] We'll go first to Stephen Volkmann with Jeffries.

[Stephen E. Volkmann:]

I'm wondering if you guys might be willing to address what's going on with pricing? I guess I'm trying to figure out vis-à-vis the kind of miss on the top line here. How much of that was things like market share? And how much might be something like pricing? And what we should expect in your order book as you kind of give guidance for 3Q and 4Q? How does pricing look in that environment as well?

[Andrew J. Cederoth:]

Sure, Steve, it's A.J. I think, the year-over-year decline in revenue is really driven primarily by volume, which is really market share and mix. I think when I look at our data year-over-year, our pricing hasn't materially changed, so the change in revenue was driven by that. Also in the quarter, the accounting correction also reduced revenue by approximately $100 million as well. So those are the big pieces in the year-over-year change. I'll let Jack comment around our strategies going forward.

[John J. Allen:]

Steve, what we're really trying to do here, and we have said this on numerous calls is, in a very measured way, gain back our market share one quarter at a time. The market is very competitive right now. There is excess manufacturing capacity in the market, and we expect the Class 8 industry to be actually down year-over-year by 7%. So the opportunities to drive pricing are really limited and probably just limited to in the most part collection of the commodity increases that all of us have experienced. On the other hand, we are very comfortable with our product line and our quality and their performance. And we're presenting a very strong value proposition to our customers.

[Stephen E. Volkmann:]

Okay, but it sounds like what you're saying is you do expect to capture the increase in commodity costs?

[John J. Allen:]

Yes, in our experience, yes.

[Stephen E. Volkmann:]

Okay, great. And then just finally on the warranty, the gift that keeps on giving, I guess. When do we get some kind of comfort level that we've kind of got all of this under control? I mean, it feels like we've been through this a couple of times, so maybe it's not even answerable, but how do you know that we're not going to see another one of these in the next couple of quarters as we continue to work through the backlog here?

[Troy A. Clarke:]

Steve, this is Troy. So let me take a shot at that. Now that the 2010 engines or a significant number of the 2010 engines are out of their base warranty period, we think that gives us a really good idea as to what the total exposure would be if we made no improvements on the quality of the engine in the succeeding years, yet we know we have. So we believe that we don't -- not just believe, but the numbers for 2011 and 2012 and 2013 are lower. Now we're trying to be a little conservative with regards to not making too -- assumptions that they go significantly lower. The second thing is, is that we have these field campaigns. And when you have these field campaigns, there's just a lot -- there's a lot of spending that's really related to making sure that the customer, who kind of didn't want his truck in there to begin with, is satisfied when he leaves. So between those 2 factors, we believe we're getting our arms around the big bore warranty spend. One of the things that now I think does maybe present some risk to us is our midrange engine spend. Those are still EGR engines, and although to a different scale, nowhere near the magnitude of the costs around the big bore engines, those engines experienced similar issues, and we're trying to get ahead of those so that we don't incur this seemingly unending pre-existing adjustment. So if we can manage those 3 things well, we're pretty confident that we have a trapped population, so to speak, of these engines, and those numbers should start coming down.

[Stephen E. Volkmann:]

If you have improved the population a little bit, is there a scenario where some this actually reverses at some point?

[Troy A. Clarke:]

It's certainly possible, and we would certainly hope that's the case, but that is -- that's kind of not how the accounting process works. We really are booking what we think is the realistic cost that these engines will experience in their life.

[Andrew J. Cederoth:]

Right, I think that it would be difficult to forecast something like that, Steve. But I think to Troy's point, there's a lot of good changes that have gone into the products in order to come up with these estimates.

[Operator:]

The next question comes from Andy Casey with Wells Fargo Securities.

[Andrew M. Casey:]

A couple of questions there. We realize this is a turnaround situation and so far the actions seemed to be good. I'm just wondering about the profitability. And A.J., you may have talked about it, is Navistar still in a position to generate positive earnings in Q4?

[Andrew J. Cederoth:]

Well, I don't think that we've gotten into that granular level of detail for Q4. I think going back to the last quarter, Andy, we talked about taking this one quarter at a time. And when you look at the changes that occurred in the business from Q1 to Q2, obviously, the warranty kind of overwhelmed the quarter. We did see lower defense revenue in Q2 versus Q1. We had a little bit of restructuring, onetime charges that flowed through this quarter. As we look into next quarter, we don't expect the warranty to repeat itself, so the warranty costs improve, volume starts to come back into the equation. In Q3, we're also seeing very nice improvement in our business in South America. That continues to improve. As Jack alluded to, we don't have a high expectation for the defense business to show a lot of signs of recovery this year given what's going on in Washington. And we'll start to see less of these onetime charges flowing through. So it will be a much purer play on the business as we come out through Q3, and then I think that starts to build momentum for Q4.

[Andrew M. Casey:]

Okay. Just a follow-up on that question. If I look on Slide 34, it looks like your dealer stock inventory has been creeping up over the last several quarters. And it seems, if I'm reading the chart correctly, to be at the highest since Q2 '08, is all of that EGR-related engines? And is there any expectation that the dealers may need help to move that?

[John J. Allen:]

Andy, this is Jack. Our dealer stock inventory turnover is at normal levels. What you're really seeing from a building up here in just the last couple of months is some of the new products, so ISX engines coming forward into the marketplace is one, along with just the anticipation here as we said all along of the second half of the year being stronger than the first half of the year. So this is a building in inventory in anticipation of a stronger market in the second half of the year. If you go back in time on this chart, boy, it goes all the way back to 2003. And our dealer stock inventory levels by any historical measure other than in the throes of the recession, our inventory levels are in fine shape.

[Andrew M. Casey:]

Okay. And then on a longer-term basis, this 8% to 10% margin goal has been interpreted a few different ways. It's very clear now, it's an exit rate 8% to 10% EBITDA margin goal. What sort of volume improvement -- I know Troy you indicated not much, but what sort of volume improvement do you think needs to occur to hit that goal? Because when we're looking at the revenue year-to-date and there's a lot going into this comment, but it's approximately $1.1 billion beneath last year, so I'm just asking it in the context of, what is the earnings promise potential when we look out to 2015?

[Troy A. Clarke:]

Yes, Andy, so thanks for asking the question because -- a large part of what we're doing here with regards to pulling costs out of running the business is to lower our breakeven point so that we could take advantage when the market does come up, okay? But the market doesn't have to go back to where it was in years past. Basically, when I kind of laid that 8% to 10% out in the groupings that you saw, we're thinking about an industry that's 240 to 250 for heavy, okay? And a market share that's in the 20s, okay? Not over 25%, but over 20%, between 20% and 25%. That's kind of the range that we're thinking about as our kind of planning sweet spot. And then as the market cycle's up, obviously, we think we're going to do a little bit better. As the market cycles down, it will shave a couple of points off, but we think that kind of EBITDA margin in that kind of volume and share makes our business a lot more robust than it has been in the last couple of years. Is that helpful?

[Andrew M. Casey:]

It is. And I was wondering, I mean, since you gave the heavy, is there a consideration for the medium duty?

[Troy A. Clarke:]

Yes. Yes.

[Andrew J. Cederoth:]

The overall industry would be in the -- this year, we're anticipating $306 million, last year was $317 million. So the 8% to 10% EBITDA is in the $325 million to $335 million ranges would be as high as it ever gets.

[Troy A. Clarke:]

Yes, and we're thinking in the medium, our share would be between 25%, 30%. So you can see there's some modesty or some conservatism and are trying to plan for that.

[Operator:]

We'll take the next question from David Leiker from Baird.

[Joseph D. Vruwink:]

This is Joe on the line for David. Just with the commentary on orders, that was good detail. If the order rates are running up 39%, but the plan is to build 25% more sequentially, is the expectation that the order progression slows into June and July? Or is it a case that the order books are nearing capacity so any incremental orders you get late in the quarter help fill out the fiscal Q4 schedule?

[John J. Allen:]

What really it is, Joe, is that when we receive orders, some are for immediate build, some the customers ask for them to be spread out over the near-term months, and that's really the phenomenon that you're seeing here relative to your calculations.

[Joseph D. Vruwink:]

Okay. Do you happen to know in terms of your plan, how much is left to go or much of your planned production still needs to be filled by orders?

[John J. Allen:]

I don't have that in front of me. As I said, we're -- our third quarter ends in the end of July and for all intent purposes, we're practically full through July. We have orders on the books for August, September and October, but also plenty of capacity to accept additional orders and build them in the fourth quarter.

[Troy A. Clarke:]

Yes. The majority of the book is not filled. Over 50% of the book is not filled for Q4 yet.

[Joseph D. Vruwink:]

Okay. And If I can just sneak in with a quick one, do you happen to know the mix of the orders you've been getting in recent months between the 13- and 15-liter?

[John J. Allen:]

I do. The last number of months, the order intake has been about 50% ISX's and the ratio between the EGR and the SCR, the SCR just keeps going up every month, but there's still a number of customers that continue to order the EGR engines as we wind down and transition.

[Operator:]

We'll go next to Andrew Kaplowitz with Barclays.

[Andy Kaplowitz:]

Troy, maybe if you can just talk about this market share run rate guidance for the end of the year or your goal. Navistar has given out these goals in the past, and we know what's happened with them occasionally in the market share goal. And then I always worry, when you give out a market share goal that with the focus on market share versus profitability, I know you're going to tell me otherwise. But maybe you could talk about your confidence level in market share sort of reaching these rates. And I know it relates a little bit to the previous question, but just how do you feel about it? I'm a little bit surprised that you've given a goal. I think that's a good thing, but at the same time, you know the history of the company.

[Troy A. Clarke:]

Yes, no, no. Andrew, that's a great question. First off, let me just kind of restate what Jack said in his presentation was he said, we would have a market share of 15% for the year, so we kind of ran that in the second quarter, right. So that implies that in the third quarter, we tick up a little bit more or between the next 2 quarters, we tick up another point or 2 just to be able to get the math to work out. So I don't think that's really overstating it, that we would be able to expect to get into the 16 kind of percent market share range, especially with the product offering that we have. And then I think the more important thing that Jack said though is that, we think we'd have an improving trend as we exit the fourth, as we exit the fourth quarter. Let me give you a little bit of a background. Number one, we think we've got some great products here. We've not really made any superiority claims or claims at all yet with regards to -- about the improved fuel economy, but the SCR systems on the truck does give fuel economy improvements, and we're getting a lot of great feedback from the folks who have had -- who have some of these trucks in their fleet. So we really do think we have something special to sell. All the proper attributes of the ProStar and the drivability and all that good kind of stuff. So we still think we have something to sell there. And then these major fleets, these are -- this is -- we're tipping in, in that fourth quarter for the period of time where you start getting the larger fleet buys come through. Now as Jack said, some of those are spread out. They will make the orders in the fourth quarter. You deliver some in the fourth quarter. And a lot of them you deliver in the other quarters as well, but I think to suggest that we go from a 15% average to an 18%, that's pretty doable, especially with regards to the market share coverage we have. Now if I had told you that we were going to go to 22%. You might say, yes, I don't know how the math works on that, right? It's kind of like you're bowling average, right? The longer you go through the year without bowling games over 200, the higher it is -- the harder it is to get your bowling average up. But I think with the order intake rate that we have right now and where we see the market going for the balance of the year, we're pretty good. We're pretty good with our estimate. And I'm not really -- I don't want to say I'm not concerned. Obviously, we're looking to sell trucks everyday, but I don't think we're overstating what we can do yet this year. And it's really important for us to get the run rate going. We need the momentum going into 2014 because even an 18% run rate is not where we want this company to be and not where this company will be.

[Andy Kaplowitz:]

Okay, okay, Troy, that's helpful. So maybe I could ask you about the overall market. I mean, you've alluded to it a couple of times in the presentation that you expect the market to improve in the second half of the year here. I mean, we all can see the order numbers for the market, and they look pretty good over the last few months, especially as we enter what can be a seasonally slower time. So maybe you can talk about that. Do you expect sort of industry order rates to sustain or even improve from today's levels and why?

[John J. Allen:]

Joe, this is Jack. Our plan was built on an increasing market for the third quarter and the fourth quarter. Not dramatically over the first and second quarter, but just a steady increase, and it really is what we're seeing. So order intake rates, we expect them to stay where they are, maybe uptick a little bit as we get into the end of the summer. As you know, typically in the June-July time period, orders receipts are a little softer and then they kind of pickup near the end of our fiscal quarter. And that's what we expect to happen. And if that does happen, we'll hit our industry forecast for the year. If you track the averages, they're tracking very consistent with what our plan has been. It's kind of the reasons why, there's, on the positive -- there's positives and negatives. Clearly, there's still a lot of concern about what's going on in the economy, concern about drivers, concern about the new hours of service regulation. But on the other hand, fleets see better performance out of newer vehicles. Better fuel economy and lower maintenance costs, whether those are our trucks or our competitors' trucks. And as they see that, those that are well capitalized and well run, they're the ones that are buying the trucks right now.

[Troy A. Clarke:]

And there is, I mean, at a macro level, there is a tick up in construction and there is a tick up in industrial activity, both of which are key indicators that drive, I think, the overall market.

[Operator:]

The next question comes from Jerry Revich with Goldman Sachs.

[Jerry Revich:]

Troy, I'm wondering if you could just flesh out for us the cost-savings opportunity from engine manufacturing consolidation now that we're another quarter in? And just, if you could, just talk about timing? Clearly, you've got a lot of capacity in that business. And just if you could step us through how we should think about when you actually move forward with those efforts?

[Troy A. Clarke:]

Yes. So, Jerry, so here's the deal. We make engines in 3 different facilities today. The fact of the matter is, we probably need 1 facility to make those engines. The problem is, is that the vintage of manufacturing technology in each of those facilities is different. Our older, more traditional products tend to use captive transfer line kind of technology which is big and hard to move and underutilized. And then, of course, when you get down to some of our operations in Huntsville, we are able to use agile, flexible machining centers. So we have a handful of proposals that we've developed internally that depending upon how much money we want to spend, will tell us that we could pull the trigger on that consolidation next year and be done in 2015 or we can do it in pieces and be done in 20 -- at the end of -- actually into 2016. So it's important that we get this done in order to get the -- to the cost rate that we're trying to get to, and we're not making any announcements today. We obviously have to -- we have to select the technical path we're going to go down, and we have to go talk to the right folks about it as well. But I would say, before the end of the year, we'll have selected that path and laid out the timing. And then you guys will hear about announcements as we're ready to make them. But look, we don't make any money with underutilized manufacturing facilities. That's just a given for our business. And the kind of circumstances we really want to be in is where we always need the capacity to build one more as oppose to having the capacity to build one extra.

[Jerry Revich:]

And, Troy, just order of magnitude of the savings, I mean, are we talking in multiples of what you're going to save on Garland or comparable levels, can you just calibrate us?

[Troy A. Clarke:]

Well, so if you think about the Garland thing, let's just say it's probably in the same Zip Code, okay? It's in the same ballpark. And again, it depends on how we do it, but it's in same ballpark.

[Jerry Revich:]

Okay. And lastly, A.J., on EBITDA guidance for the third quarter on 25% higher production rates. I think that implies now under 10% incremental margins and you folks typically have high absorption when you ramp production. I'm wondering if you'd just step us through what are the sequential headwinds that we should be thinking about or is it just a function of, hey, we've got a new product cycle here so we want to make sure we can execute.

[Andrew J. Cederoth:]

Well, I think, there's a couple of things that are influencing us this year, Jerry. First, there is quite a bit of moving around within manufacturing, so we've got some start-up costs factored into that quarter as we ramp-up production in Springfield and realign manufacturing. The second thing we've talked about is with the addition of SCR to our products, we are adding material cost to our products during this transition. We've talked around the timetable that it will take to properly design the SCR system and to optimize that integration into the truck, we won't have that done in Q3. That will be things that come in 2014. So during this transition period our margins will be a little bit lower because we've got added material content on the truck.

[Operator:]

We'll take the next action from Ann Duignan with JPMorgan.

[Ann P. Duignan:]

A lot of my questions have been answered. Troy, can you just talk us through what exactly happened that caused the disappointing market share at this point? And then what is Plan B if we turn around a quarter from now, 2 quarters from now and the market share has stalled out at the 18% or whatever?

[Troy A. Clarke:]

Yes, so I guess I referenced when I set that up in my comments, we had expected our market share to ramp-up faster. And in the heavy, quite frankly, we thought the take rate on the ISX would have been much faster in the ramp-up than it really was. If I could just be extremely candid, we recognize that the -- we were in the process of changing that 13-liter and so you kind of either like EGR or you don't like EGR, but that was kind of be what it was going to be. And what our plan really was, hey, ISX and the ProStar. I've had fleet managers tell me they think that's probably the best truck that they've ever had. And so kind of on that anecdotal evidence, we thought the take rate would be higher, okay? And quite frankly, maybe this is a good thing, as Jack noted, orders are still coming in kind of 50-50, 15-liter and 13-liter. So I guess those who say, really there is no 13-liter segment of the market, it's really a 15-liter segment, then you're pricing down for 13, that may be not true. It turns out there's a lot of folks out there who like the 13-liter. So I would tell you that, that's kind of at the beginning of that. With regards to the, what's Plan B if the market share on our heavies doesn't increase? Well, I guess Plan B, the first part of that is, we're going to go figure that out. We think we have a product that's extremely competitive. And if it's not selling, then we're probably not doing something right, okay? And then the second thing is, I think this probably gets maybe to -- maybe to what your question is, can you successfully run the business at an 18% market share over 240,000 or 250,000 units heavy market? That's probably tough to do. I mean, that's probably just below where we think our -- in the breakeven range that we're at. So haven't fully studied that up. I mean, obviously it's just numbers, but I think we'll keep focused for the time being on getting our market share back. And Jack referenced this process that the guys have put in place to make the sales process a little more visible for us. And quite frankly, it's a great process, and I'm very encouraged by the opportunity for us to get in front of folks and tell our story. Ann are you still there?

[Operator:]

Hearing no response, we'll move to the next question. It comes from Brian Sponheimer with Gabelli & Company.

[Brian Sponheimer:]

One of the positives in the quarter was the Parts segment. Just talk about how repeatable this is? If it's kind of mid-teen profit margin and what you're thinking about kind of going forward?

[John J. Allen:]

This is Jack, Brian. Our Parts business was very good in the quarter. Really, so far in the first half of this year. There's been a uptick in military parts on the revenue side, on the North American side, although the sales are not as maybe as robust as what we'd like. As part of our overall structural cost reductions, we've gotten extremely lean in the Parts business. And we've also employed some very sophisticated pricing strategies. And the combination of that has improved our margins and lowered our cost, and we absolutely believe that's sustainable going forward into the third and fourth quarter.

[Brian Sponheimer:]

All right. I appreciate that. Just A.J., just for a second, talk about the out-of-period adjustment with GE. And if this is something that we should expect in Q3 and Q4 and the first quarter of next year?

[Andrew J. Cederoth:]

Well, I'll answer the second question first, no, we don't expect to have any more out-of-period adjustments. What this is really related to our fleet transactions that get financed through GE Capital with a lease. And the complexities of lease accounting really dictate that we should amortize that and not treat that as a true sale, even though we did sell the truck to the fleet who subsequently financed it. So that's really what's driving that. It's kind of, as we gain momentum here, this volume of financing has really risen to the level that we checked it a little more carefully this quarter and found that it's probably more appropriate that we amortize those transactions over the life of the lease rather than book the sale at the time of the sale. Again, not a big impact to the bottom line, but it is corrected, and we'll treat it correctly going forward.

[Brian Sponheimer:]

Okay. And not to beat this into the ground, but just on the warranty side, should I be reading correctly that we're going to be looking at a medium duty engine campaign at some point in 3Q or 4Q?

[Troy A. Clarke:]

No, we've made no announcements with regards to field campaigns on the medium duty. And at present, we're managing through the normal warranty system. By the way, let me just say, there are small campaigns that probably affect most of our products on minimal kind items, so not a large field campaign that we have yet to announce, okay?

[Operator:]

And we'll go to the next question that comes from Rob Wertheimer with Vertical Research Partners.

[Robert Wertheimer:]

Let me circle back to the GE financing, was there any change in commercial practice that led to this? I mean, I guess, A.J. mentioned the volume got bigger, but was there some sort of a different practice? And then does it relate to either an enhanced trade-in price and/or a change in your residual values that would make that whatever trade-in price was offered more relevant?

[Andrew J. Cederoth:]

The answer's no. There was no change in any of our commercial practices. It was really just the volume of the business reaching a level that we did some further investigations. It's really driven by our overall commercial agreement with GE Capital, not any specific transaction of a deal.

[Robert Wertheimer:]

Okay. And then I just want to make sure I understand, when the 2010s go out of base warranty, does that mean the exposure that you have is over? Or I'm not sure I understand the distinction between that and some of the campaigns you might do to keep customers and customer retention, et cetera. I don't know whether you're out of the woods on those or continuing to fix them even though they're out of warranty.

[Troy A. Clarke:]

So Rob, we have kind of 2 things we do. One is, we do have some extended warranties on a portion of that population, and which is an industry convention, so you have a normal warranty and an extended warranty. The customers pay for that extended warranty, so we just have to extend the warranty period and that ends up getting netted against what we end up having been paid for that. And then the second thing is, is in the vehicle industry as a whole, there's a thing called policy. And, look, if someone is 1 mile or 1 week over the their warranty period and the truck breaks down and comes into the dealership, that's the kind of thing where we would use discretion and probably cover that under the original warranty. So the important thing of what I said though was, we have a statistically significant sample of 2010s that are through are their base warranty period. So given the volume of that product and the failure modes that we've observed, we believe we have a very good view of the potential failure modes. And at least through that base warranty period, through the probability of failure for anyone of those major, major systems.

[Operator:]

The next question comes from Patrick Nolan with Deutsche Bank.

[Patrick Nolan:]

First question for Troy. Can you -- I just want to revisit the variable cost savings and particularly the material cost that you referred to. Does the redundant or however you want to describe it, the EGR components that ultimately will come out of the 13-liter engine, does that come out on a model year basis? Is it something that will be done gradually over time that takes several years? How should we think about how that cost comes out over time?

[Troy A. Clarke:]

I think right now we're planning on taking 2 slugs at it. The first -- let me put it this way, there's some truck pieces and there's some engine pieces. So on the engines, they are in effect EGR coolers that we no longer need to -- that we no longer need. When we reengineered those off the engines, those are significant emissions component, and so we have to recertify the engine with the EPA. And so that piece will -- we've already embarked upon that process. And in fact, I would anticipate that next year, early next year, first half of next year, let me put it that way, we'll recertify the engine and be able to pull those pieces off. After we pull those pieces off, there's pieces on the truck, like an additional radiator, which really exist to service those coolers and some other things. And then -- so then after that, then we'll engineer that off and so that will be kind of the second tranche that I want to anticipate will get done by 2015 or early in 2015. So from an engineering workload right now and having to certify the engine with the EPA again, we've decided to do it in 2 pieces.

[Patrick Nolan:]

That's very helpful. And if I could just ask one follow-up for Jack. The overall Class 8 share actually improved versus Q1, but the severe service took another dip down in Q2. Did that have to do with the leasing companies? It's kind of similar to the trend that we've seen in medium duty or was there some other trend going on there?

[John J. Allen:]

Well, first off, it's not really related to the leasing companies. It's really primarily more driven by municipalities. Our severe service market share traditionally has been very strong in the government business. And as you would imagine, with what's going on in state and local budgets, the municipality businesses is off a bit. I will say though that our order intake in the severe service side has recovered a bit here during that quarter and in the month of May, so we think we'll get that back. And the other thing you have to remember, the severe service portion of overall Class 8 is small, so it doesn't take many sales to really move up or down what your market share is.

[Operator:]

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

[Seth Weber:]

Most questions asked and answered, but on the medium duty transition to Cummins aftertreatment, do you expect any disruption or hiccup? Do you think customers will wait for that or you think that's just a seamless transition.

[John J. Allen:]

I think it's a pretty seamless transition. We've been in the market with our EGR version going to SCR. This has been expected by the industry. We have alluded to it before. So we expect that will just be a smooth transition.

[Seth Weber:]

Okay. And then just -- as you look forward into next year? I think previously, you've talked about the 13, 15 mix being kind of like a 50-50, is that still the right way to think about it?

[Troy A. Clarke:]

We don't see anything different today that would make us feel differently.

[Seth Weber:]

Okay. And then -- and sorry, just lastly. Did I hear correctly no NCPs in the third quarter?

[John J. Allen:]

I think if you're referring to my comments, what I said was, that we -- due to the plan we put in place on medium duty, we don't anticipate that we'll have any NCPs on medium duty engines.

[Operator:]

We'll go next to Tim Denoyer with Wolfe Research.

[Timothy J. Denoyer:]

Just one more quick one on the accounting, the revenue recognition. On the cash flow statement, there was $263 million in proceeds from finance obligations. Can you explain, was that related to the accounting change and can you explain what that cash inflow was?

[Andrew J. Cederoth:]

Yes. It's not really -- it's an accounting statement, Tim, so it's not truly a cash inflow. That's recording the deferral. There's an offsetting cash flow up above that, so the true cash flow is 0.

[Timothy J. Denoyer:]

Okay, so it's a net-net, net 0.

[Andrew J. Cederoth:]

Yes, sure.

[Timothy J. Denoyer:]

And can you give any timing on the medium duty transition over to SCR at this point?

[John J. Allen:]

Well, we'll start in the first calendar -- first quarter of calendar 2014.

[Operator:]

We'll take the next question from Joel Tiss with BMO.

[Joel Gifford Tiss:]

I just had one big question. It looks like the structural cost for the last 2 quarters have been running about $100 million below year-over-year between the SG&A and the engineering cost. And I just wondered, obviously, that's a $400 million annual run rate. And I just wondered if you could give us any, like what am I missing when the gap between that and the $200 million that you guys expect of full cost savings?

[Andrew J. Cederoth:]

That's because what you're seeing there is the quarter-over-quarter, where costs were higher in Q1 and Q2 last year. We had a pretty significant cost reduction effort in the second half of last year. So as that run rate will slow because we reduced cost in the third quarter and the fourth quarter, but we do expect to exceed our target.

[Joel Gifford Tiss:]

Right, yes, because there's a lot of add-ons on top of that, closing down businesses and things like that.

[Andrew J. Cederoth:]

Right, yes.

[Joel Gifford Tiss:]

And. I didn't know, I didn't catch it if you mentioned...

[Operator:]

I apologize it'll be just a moment, we'll get that gentleman back on the line [Operator Instructions] [Technical Difficulty]

[Troy A. Clarke:]

We didn't catch your second question.

[Joel Gifford Tiss:]

Sorry, I got cut off too early. The cost to complete the field campaigns, I don't know if you mentioned that or not.

[Andrew J. Cederoth:]

No, we did not.

[John J. Allen:]

Yes, we did not.

[Troy A. Clarke:]

The cost to complete -- one of the things we tried to emphasize was the accounting is a little difficult to handicap because it's very driven by how we spend the money and where. But the amount of money that we are spending has been incorporated into our forecast, and we have a forecast for Q3. We don't reveal it in that level of detail, but we are spending it the way we thought we would spend it.

[Operator:]

That concludes today's question-and-answer session. At this time, I'd like to turn the conference back over to our speakers for any additional or closing remarks.

[Troy A. Clarke:]

Hey, again, I certainly appreciate you hanging in there with us this particular quarter with regards to the rescheduling of the call. Again, I apologize for having maybe disrupted your agendas. For those of you who did not get an opportunity to ask a question and you got something burning, please call Heather. We're hanging around, and we're available throughout the week so we can make an opportunity to chat with any of you with regards to the questions you maybe didn't get to ask or anything you need clarified. Thanks a lot, and we look forward to seeing you all in person in the near future.

[Heather Kos:]

Thank you.

[Operator:]

That concludes today's presentation. Thank you for your participation.