Navistar International Corporation
Q3 2014 Earnings Call Transcript

Published: 3 Sep 2014

[Operator:]

Good day, ladies and gentlemen, and welcome to the Navistar's Third Quarter 2014 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, this conference call is being recorded. I would now like to introduce your host for today's conference, Heather Kos, Vice President of Investor Relations. Ma'am, you may begin.

[Heather Kos:]

Good morning everyone, and thank you for joining us for Navistar's third quarter 2014 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 Walter Borst, our Executive Vice President and Chief Financial Officer. 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 web site 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 Forms 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 Clarke:]

Thank you, Heather, and good morning everyone and thank you for joining us. This morning, Walter, Jack and I are pleased to review our Q3 financial results, and update the progress of our Drive to Deliver. On our first quarter earnings call, we indicated, we would demonstrate meaningful quarter-over-quarter improvement. We continue to make such progress, and achieve significant milestones this quarter. Let me highlight what we are going to talk about today. First, income from continuing operations before income taxes of $21 million; for the first time since 2011, this was positive for the quarter. Second, EBITDA, we reported $133 million of adjusted EBITDA for Q3, which was better than our projected guidance range; and third, we continue to meet our targets on cash. In Q3, we once again hit our cash guidance and this is our eighth consecutive quarter of cash management, to meet or exceed our goal. Next, we will talk about industry and share. The North America traditional industry continues to grow beyond our forecast for the year. We anticipate the Class 6-8 truck and bus market to reach between 330,000 and 340,000 units during our 2014 fiscal year. Backlog; production and charge-outs were up year-over-year. We continue to receive very positive feedback from our dealers and customers, and our commitment to quality, the excellent performance of our products, great fuel economy, and outstanding uptime. Also, we are reporting reduced spending in the quarter, our lean initiatives, engine restructuring and previous reduction in core [ph] sanctions have helped us further lower our structural costs; and in the quarter, we achieved $86 million of structural cost savings. Given this performance, we are raising our year-over-year target to $300 million. We continue to take aggressive actions and implement lean principles, as we optimize our cost structure. And finally, Brazil; Brazil's economic situation continues to challenge the entire industry. We expect an 18% decline in engine volume versus last year, and we have dealt with this headwind all year, and we have made significant progress lowering our fixed costs. We expect improved profitability, as we the economy recovers. The slower than expected market share gain in the last two quarters is behind plan, and our results demonstrate that we are more flexible, agile, and lean than many may think. We continue to drive our breakeven point even lower; and as time progresses, we are recovering marketing share, as more customers experience our new SCR product. We are making significant progress, and we are building the right kind of momentum for the future, and you will see more good things, as we move forward. On the whole, I am pleased with the progress we have made towards the goal of exiting 2015, at our 8% to 10% EBITDA run rate. And with that, let me turn the call over to Walter and Jack, and I will be back to wrap up with some comments on the remainder of 2014 and 2015. Walter?

[Walter Borst:]

Thank you, Troy. Good morning everyone. I'd like to turn your attention to the financial results for the quarter on slide 9. We continue to see benefits from our Drive to Deliver plan. Revenue for the quarter was $2.8 billion, essentially flat compared to the third quarter of 2013. Year-over-year revenues from our North America truck segment were also flat, reflecting 10% higher sales in our traditional markets, offset by lower military revenues. North America products segment reported a 4% year-over-year increase in revenues, reflecting higher volumes in our commercial markets. These increases were more than offset by lower revenues in our global operations segment, primarily due to lower engine volumes reflecting the economic downturn in Brazil. For the third quarter, EBITDA was $142 million, growing considerably both sequentially and year-over-year. Income from continuing operations before tax was $21 million, compared to a loss of $211 million in the third quarter of 2013. The improvement reflects continued reductions in structural costs, as well as lower warranty expense. The testament of our strong quality and focus on costs, to show this type of earnings improvement with relatively flat sales. The reduction in warranty expense speaks volumes on the improved performance in quality of our products, and the continued reduction in structural costs, reflects the team's dedication to our new lean culture and focus on lowering the business's breakeven point. As shown on slide 10, adjusted EBITDA for the quarter was $133 million, beating our guidance of $75 million to $125 million. This is the fourth consecutive quarter we have met or exceeded our guidance. There are two adjustments that I'd like to point out. First, we reversed $29 million in prior period warranty approvals, primarily related to extended service contracts, reflecting lower costs for repair. Also, the standard warranty claim data on our newer products are trending favorably; and second, we incurred $20 million of restructuring and asset impairment charges, which principally included incremental pension related reserves, stemming from a recent governmental ruling in Canada, which we have appealed, relating to the 2011 closure of the Chatham, Ontario plant. On slide 11, you can see the quarterly results for our business segments. The North America Truck segment reported a loss of $12 million, compared to a loss of $143 million in the third quarter of 2013. The improvement in the segments results reflects higher truck volumes, lower warranty expense and lower structural costs. And North America Parts segment, reported profit of $127 million, up 30%, reflecting stronger performance in our commercial markets. The global operations segment was close to breakeven this quarter, versus the loss of $22 million in the year ago quarter. This reflects improved geographic mix, and lower structural costs. On the other hand, the economic downturn in Brazil continues to challenge our operations in the region. Financial services segment continues to perform in line with our expectations. Segment profit in the third quarter was $24 million. Despite lower overall retail balances, financial results improved, due to lower structural costs and the interest income from an intercompany loan. Turning to slide 12, we ended the quarter with manufacturing cash, cash equivalents and marketable securities of $1.1 billion. During the quarter, adjusted EBITDA more than offset the cash used for capital investments, interest payments and pension and OPEB contributions. Additionally, warranty cash payments exceeded warranty expense, which is expected to continue in the near term. Also this quarter, the manufacturing operations established a new $90 million intercompany loan from our captive finance subsidiary, NSC, which was not included in our cash guidance. After adjusting for this loan, manufacturing cash came in at the midpoint of guidance. Turning to slide 13, we expect manufacturing cash at the end of the fourth quarter to be in the range of $1 billion to $1.1 billion, after repaying the remaining $166 million of our 3% convertible notes that come due next month. For the fourth quarter, we expect operating cash flow to be positive. Expectations driving this include $115 million to $165 million of consolidated adjusted EBITDA, which excludes preexisting warranty accruals and onetime items consistent with prior quarters, and a favorable change in net working capital, due to increased volume and the higher number of operating days in the fourth quarter. We also expect cash used for capital expenditures and pension and OPEB funding to be lower than in the fourth quarter of 2013. This reflects the benefit from the recent passage of the pension funding stabilization legislation, which has lowered our funding requirements to $66 million for the fourth quarter and $164 million for this fiscal year. Slide 14 puts a few of our key operating metrics into historical context. Manufacturing revenue in the third quarter was up 4% compared to last quarter and flat year-over-year. We believe revenue will continue to grow in the fourth quarter of 2014, as we continue to transition our product portfolio, and roll out derivative models. Structural costs continue to come down year-over-year. For the quarter, structural costs as a percent of manufacturing revenue was 11.4%, three percentage points lower than in the third quarter of 2013. We are trending favorably, as we work towards our structural cost bowl of less than 10% of manufacturing revenue. Warranty expense is also improving. During the first nine months of this year, warranty expense as a percent of manufacturing revenue was 4.2%, compared to 7.7% for all of last year. We are on course to achieve our goal of decreasing warranty, as a percent of manufacturing revenue by four percentage points. The adjusted EBITDA margin for the quarter was 4.7% versus 3% in the second quarter of 2014, and nearly breakeven in the third quarter of 2013. Slide 15 shows the progress on our goals for 2014 and beyond. As Troy previously mentioned, we now expect industry volumes of 330,000 to 340,000 units for 2014, including Class 6-8 and bus. Traditional market share has not recovered as quickly as anticipated, but we expect the gradual improvement over time. Jack will elaborate further on industry volumes and market share shortly. We continue to outpace our goals for structural cost savings. Through the first nine months of this year, we have realized $245 million of year-over-year savings. As a result, we are raising our full year 2014 structural cost savings target to $300 million. Our business continues to improve, as we execute our Drive to Deliver plan. In the third quarter, we reported income from continued operations before tax and adjusted EBITDA that beat our guidance. For the fourth quarter, our adjusted EBITDA and cash guidance build upon these results; and we remain on-track to achieve our EBITDA margin target of 8% to 10% exiting 2015. August 1st marked my one year anniversary with the company. As I look back on that first year, the company has made significant progress on the operating side of the business, by introducing new products, improving quality, and reducing costs. At the same time, our effective cash management and balance sheet activities have allowed us to maintain a strong liquidity position, while extending our debt maturity profile. After generating income from continuing operations before tax, and close to breakeven net income this quarter, the next steps from a financial perspective are to continue to improve on these quarterly results year-over-year, and to generate positive cash flow, so that we can further improve our capital structure. As you can see, we are progressing in the right direction, and I am extremely proud of our team. I will stop here and let jack provide more insight on our Drive to Deliver plan. Jack?

[Jack Allen:]

Thanks Walter and good morning everyone. My remarks today will center around our operational progress in Q3. To be successful this quarter, we needed to address three important areas that were dragging down our financial results, and I am pleased that we are able to accomplish it. First, is the quality of our products and warranty expenses, and we are ahead of where we thought we'd be at this point in the quarter. Second, is our cost structure and breakeven point, and we are ahead here also. Our final hurdle is to improve sales. Here we have made significant strides in rebuilding relationships with customers. It started by taking care of the trucks in the field, and then getting our customers the right products to run their business. With the introduction of the severe service SCR in July, all of our major SCR products are now in production, and we will continue to introduce more applications and variations throughout 2015. So let me start with warranty on slide 18; its a good news headline for the quarter. Our warranty spend and our expense continue to come down. Q3 warranty spend was down 22% year-over-year and 14% since the last quarter, and the spend is coming down for three reasons; the cost of each repair is declining due to better repair practices; the improved quality of the new SCR engines is driving a lower warranty spend on these engines, and to a lesser impact, fewer ETR engines are in the warranty period. We believe this lower warranty spend rate is sustainable, and will result in spend and expense at levels consistent with industry norms. In addition, our new remote diagnostics product, OnCommand Connection, will enable us to further decrease our warranty expense. It helps to increase vehicle uptime and supports quicker repairs, and helps to control maintenance and repair costs. Turning to slide 19, the second area where we overperformed in the quarter was in delivering the cost improvements, mainly to lower our breakeven point. We saw excellent results in material, manufacturing, SG&A and engineering, in addition to the lower warranty expense we have already highlighted, these improvements were made by applying the lean principles of continuous improvement and waste elimination. Our overall lower cost structure will improve profit leverage, as volumes improve. The foundation of our business has improved dramatically. We have the right lineup of SCR-based Class 6-8 trucks and buses, product warranty is declining, uptime is improving, order backlog, production and quoting levels are all up year-over-year, the quality, fuel economy, and driver acceptance of our new trucks is improving, and our dealer body is healthy and investing in the future. These are all indicators of improving performance, and we are encouraged about the upcoming 2015 buying season. On slide 20, chargeouts in the quarter were up year-over-year, in medium by 6% and heavy on the highway by 24%, where we have had SCR products in the market the longest. But down in severe service by 18%, where as I mentioned, SCR is just now being launched. Its important to note that the product line, where we have had SCR products the longest, Class 8 on highway, with the ISX and with the MaxxForce 13 SCR is growing the fastest. Our market share for Class 8 in the quarter was 14%, and therefore we expect to see a similar growth story in medium and severe service in coming quarters. We are also encouraged by the recovery we see in school bus, with charge-outs up 15% year-over-year, and we expect that to continue with the announcement we made yesterday to add propane engines to our product line, and time for the 2015 school year. On slide 21, our North America Parts business continues to be a good news story, delivering strong performance in the quarter with sales up 4% year-over-year. North America Commercial led the way with sales up 9%, the second highest quarter on record. Q3 was another good quarter for used truck sales, with sales up 29% year-over-year. Our Diamond Renewed program, which we launched in the third quarter, has created a lot of interest in the marketplace. We are raising the bar by providing our used truck customers, with a new truck experience. It includes a comprehensive inspection, mechanical reconditioning process, and up to a two year 200,000 mile warranty. We believe Diamond Renewed is an industry game changer, and will set us apart from the competition. On slide 22, another point of our differentiation is OnCommand Connection, which I mentioned earlier. More than 50,000 vehicles across 75 customers are now supported by OnCommand Connection. One of our fleet customers, who has used the diagnostic data for six months, experienced a 28% reduction in down days, and 31% reduction in repairs. These are all leading indicators of improved performance, and we have also launched a standard offering of OnCommand Connection, on all Diamond Renewed used trucks. So to sum it up, we have made good operational progress on our Drive to Deliver in Q3. Our trucks are performing well, our breakeven is lower and our foundation is strong for improved sales in Q4, and into 2015. Now I will turn it over to Troy for some closing remarks.

[Troy Clarke:]

Thanks Jack. As Walter and Jack just shared, our financial and operational performance demonstrates the momentum we are building. These trends will continue throughout the remainder of Q4 and 2015. Regarding the fourth quarter 2014, let me summarize the points related to our guidance, which drives our belief and the continued progress to come. We believe Q4 chargeouts will be up year-over-year. Manufacturing cash is expected to be in the range of $1 billion to $1.1 billion. Q4 EBITDA guidance is $115 million to $165 million, excluding prior period warranty and significant onetime items. We project continued progress on our structural costs, and improving material cost performance in Q4. Our full year 2014 forecast has changed slightly. We raised our combined Class 8 industry average to 235,000 to 240,000, and we project the more gradual improvement in our market share. Our structural cost savings target is $300 million, with our manufacturing and consolidation efforts and adoption of lean practices, we have increased our plant, first line quality and lowered inventory. Our $50 million to $60 million of year-over-year manufacturing cost savings remains on track, and more opportunities for cost reductions remain. Entering calendar year 2015, we will reduce another $1,400 in cost from our 13 liter SCR engine. Let me reiterate our goal of an 8% to 10% EBITDA run rate exiting 2015 remains on track. That brings me to my final comments, on the sustainability of our results. Two years ago, Navistar began the Drive to Deliver plan of rapid and profound change. We have significantly improved the quality of our products, we have reduced our warranty expense, we have restructured our business, lowered our structural costs and improved the uptime of our vehicles with offerings like OnCommand Connection. These accomplishments also reflect significant ongoing changes in the Navistar team at all levels. Together, we have strengthened our customer focus and committed ourselves to continuous improvement, although we are pleased with this quarter's progress, we now believe that we are entering the next phase of our journey. Be assured, we will continue to accelerate this progress. Thanks for your time this morning. Let me turn it back over to Heather and let's open this up for any questions or comments that you might have.

[Heather Kos:]

That concludes our prepared remarks. But before we go to questions, to be fair, we ask that each of our limit yourself to one question, including an optional follow-up. SO operator, we are now ready to open the line.

[Operator:]

(Operator Instructions). Our first question comes from Jerry Revich of Goldman Sachs. Your line is now open.

[Jerry Revich:]

Good morning.

[Troy Clarke:]

Hey Jerry.

[Jerry Revich:]

Walter, I am wondering if you could just comment on the warranty process, now that you have been on board for over a year? I know, you have been dealing with the material weakness that you have been reporting, and your out-of-period warranty reduction would have been even more significant without mark-to-market on some of the out of period errors. So can you just update us on where you're on in the process, and then from a quality standpoint, I am wondering if either you or Troy can just touch on whether the type of warranty accrual performance we saw this quarter for the base business excluding out of period is sustainable heading into 4Q?

[Walter Borst:]

Yeah, it's Walter. We are making good progress I think on the warranty side on a number of fronts. As you alluded to, we have a material weakness in that area and we continue to clean that up. We did find a few items that we needed to correct and we did so in the quarter. We will call that out in our Q, to provide additional disclosure around that. But we are making good progress in that area, there are still little ways to go there though, we are not declaring victory on that front year. As it relates to the performance though, as Jack and I both alluded to, we are seeing good progress in terms of reduced spend per unit, and so the quality actions I think that the company has taken and the efforts in this area are really starting to pay off. And we have really put a lot of effort into this area over the last year, stood by our customers, but also worked very hard internally to reduce the spend, which as we have indicated before, ultimately is precursor to what might ultimately happen on the expense side as well; and we are fortunate this quarter, as we kind of looked at everything that we were able to reverse some of the accruals that we had taken in previous quarters, and we will continue to do that in every quarter going forward. But really, this is a function of our focus on quality, and perhaps Troy or Jack would want to comment on that.

[Troy Clarke:]

No look I mean -- so the question whether its sustainable or not, I mean I think buried in there is an accounting question, do we anticipate future reversals, that's not the kind of thing I think that we forecast, to be very honest. That's not how the process works. What Walter did comment on, that I think is worth to note is that, warranty spend is coming down, and it is coming down for the right reasons. The trucks we have fixed are staying fixed. So the repairs and kind of reengineering that we have put into making the EGR product better, has worked. Our cost of repairs is coming down, is coming down because we have engineered better processes, better times to be able to fix these products to be faster and more efficient. And then last but not least, the newer trucks, even the newer EGR trucks, just from the get-go, don't have the same kind of warranty spend, early in their life that the older trucks do, and then certainly the SCR products are another step better than those, as well as now that we do have a percentage of purchased engines in the portfolio, we have a mix issue that starts to work in our favor. So all of these things are driving the spend number that Walter referenced in the right direction. And I again can't comment on how the accrual works, but with regards to the spend; I think we have a laser-like focus on managing this spend and continuing to improve it. I don't know Jack, if you'd add anything?

[Jack Allen:]

Jerry, I would just add, these are all positive indicators or how we view sales prospects going into 2015 early, as we have mentioned, we are not where we had anticipated being, and I think a lot of that has to do with customers really wanting to gain experience with our new products before they increase their percentage of their buy [ph] in our favor. And as we see these indicators and its manifesting itself in warranty spend, that's another sign of encouragement.

[Jerry Revich:]

And Jack my follow-up would be just on that last point, the buying cycles tend to be pretty lumpy on the medium duty side; wondering if you'd just comment on how the customer discussions are headed versus your initial expectations, and can you update us on when do you expect to have the full product range with the ISP available as well?

[Jack Allen:]

True. If you look at medium duty, we go back a little bit into late last year; we had a very good initial surge in fleet orders, when we announced the ISP last fall and also -- from our dealer channel also. So we've built today, over 7,000 vehicles with ISPs and about 5,000 of them are currently in service. The fleet business is -- those trucks are in service, and a lot of the dealer trucks are working their way through body companies and into deliveries. So the customers are gaining experience, the data that we are getting back is very positive, on fuel economy, on performance, on uptime. So we do expect repeat business, but as importantly, we expect a greater portion of existing customer business, and our boarding activity would indicate that. Jerry, there is about a 10 or 12 customers on medium duty that make up over half the sales, and we know exactly who they are. We meet with them often, they all have vehicles, new vehicles of ours running in their fleet. We monitor their performance constantly, and we expect that going into 2015, we will garner a greater share of their business.

[Jerry Revich:]

Thank you.

[Jack Allen:]

Sure.

[Operator:]

Thank you. Our next question comes from David Leiker of Baird. Your line is now open.

[Joe Vruwink:]

Hi. Good morning everyone. This is Joe Vruwink on the line for David.

[Heather Kos:]

Hi Joe.

[Troy Clarke:]

Hi Joe.

[Joe Vruwink:]

Wondering if we can start on just your order development during the quarter? It looks like you saw a 5% decline in intake, and what looked like a pretty strong industry environment during July. Wondering, is this is a function of just customer timing, is it competitive development, is it, as you alluded to, some of the introduction of your new product, just anything you can say there?

[Jack Allen:]

I think it’s a little bit like the question I just tried to answer. A lot of this in the quarter is really built on the customers that have taken delivery of our products early in the year. Working their way through the experience, providing us feedback, providing them information about how the vehicles are performing through our OnCommand Connection system, and so that's the essence of it. I think what is important, is if you look at Class 8 on highway, where we have had the vehicles the longest, the SCR vehicles the longest in production. This is where we continue to see a positive trendline in terms of our sales increase. Our retail sales in the third quarter for on-highway were up 20% some and the area that continues to drag us down is the severe service where, until just in July, we hadn't had any SCR products in our pipeline [ph].

[Joe Vruwink:]

Maybe on that point, when you look at the nine to 10 liter products and these two segments, sort of 6-7 truck and Class 8 straights, any sense of what pieces of those market are typically buyers in that engine displacement size that you now have a product directly for?

[Troy Clarke:]

Well medium duty, its in the 10% to 15% range, but in the severe service market, the 9-10 makes up over 60 -- looking at another guide, 60% to 70% of that segment with the remainder being 13 liters.

[Joe Vruwink:]

Okay. So maybe the read here is its not so much on the near term market share figures inflecting meaningfully higher, but when you look into next year in the 22% to 24% targets, do you still feel good about those?

[Jack Allen:]

We will continue to make gradual progress, as we mentioned in our market share front. Clearly, it has come back a lower than what we had thought. We had indicated that we thought we could end this year with 21% run rate, with the higher industry, its likely to be a point or two less than that, but we will continue to see progress. As we look at our Q4 order board, we will build over 20% more trucks in the fourth quarter, than we did in the fourth quarter of last year. So for us, that's continual progress.

[Troy Clarke:]

Hey Joe, this is Troy, I would just make reference to Jack's prepared remarks; when we launched the Class 8 product, certainly, we wanted it to be kind of a snapback in terms of demand, but what we really saw was a lull there, while people worked the demos through and got their head around what the new product offering was. When we decided the launch of the ISP into the medium duty, as a shorter route to SCR for us, of course, we did that a little bit different, with the thought that we need to kind of stimulate demand in the shorter term, but actually we have kind of seen the same thing, and I think what we are seeing on that is, we are kind of exiting that lull in terms of medium duty orders, and I think the quoting activity that we see, would indicate that it’s a very similar phenomenon to what we experience in the Class 8 on highway. And I think that's kind of what we will expect and experience on the 9-10 as well. We certainly would love these recoveries in market share to come out of the gate a little bit faster, but I think we understand that phenomenon better now, after having gone through two of these major launches. Those are the comments that Jack was really making in his comments. The good thing is, it gives us confidence, we know what's happening, and we know that those orders are coming, and we see that in our quoting activity already. The bad news is its never fast enough.

[Jack Allen:]

I think it was also encouraging Joe, is that when you look at what we have done on the cost structure side, and where we have been able to over deliver here. So if you look at the quarter, as Walter said, for us to essentially breakeven in the quarter at volumes that were below our expectations, that's encouraging to us, because we do have a lot of confidence that the volume will come.

[Joe Vruwink:]

That all makes sense, and the cost performance clearly has been great. That's like you said, it never comes quickly, but having the revenues fall in place will be the final stuff. I will leave it there and thanks very much.

[Troy Clarke:]

Thank you, Joe.

[Operator:]

Thank you. Our next question comes from Jeff Kauffman of Buckingham Research. Your line is now open.

[Jeff Kauffman:]

Thank you very much and congratulations guys. Question probably more for Walter, Jack; the chart that you show I think its on slide 20 of your presentation, which -- or 18, where we have seen kind of the ageing of the vehicles subject to the warranty reserve. Its kind of hard to read the numbers, but could you give us an idea of what the 2010 to 2012 heavy duty units you expect as of November 2014, according to those charts, and kind of as the follow-up, you have also been actively repurchasing some of these units, regearing them, reselling them back into the used network. I am assuming that that is also taking that population of 2010 to 2012 EGR engines down at a faster pace. So can you give us an idea of realistically where these numbers could be at the end of this year, say relative to the end of the last fiscal year, and update us on the success of that repurchase program?

[Walter Borst:]

Well, the chart does reflect what we expect to happen in this year, and basically, what this chart is intending to do, is to demonstrate that the -- we are past the peak of what we view as being our warranty expense period. But we still have a vast majority of the EGR big bore engines that we built, are in warranty. I think it's -- over 90% remain in either their standard or their extended warranty period.

[Jeff Kauffman:]

Okay. So if that number was peaking around 60,000 during the calendar year 2013, where do you expect that number to be towards the end of this fiscal year, including some of those engines that you're repurchasing and repurposing?

[Walter Borst:]

Well that's not -- I mean, we are going to have to get back to you and then answer on that question, because that's not what this chart is intending to depict is. This chart doesn't show how many vehicles are coming out of the warranty period.

[Jeff Kauffman:]

Right, and that's why I am asking the question. Okay, well I will just get back to you offline with that. Thank you very much.

[Operator:]

Thank you. Our next question comes from Stephen Volkmann of Jefferies. Your line is now open.

[Stephen Volkmann:]

Great. Good morning everybody.

[Heather Kos:]

Hey, how are you?

[Stephen Volkmann:]

Great. So I am wondering if we can just look at the fourth quarter a little bit. I think Jack, you said something about your build plan year-over-year was up. Is it up sequentially, and if so, can you give us a sense of that?

[Jack Allen:]

Its up slightly sequentially.

[Stephen Volkmann:]

Up slightly. Okay. And how do you -- based on the backlog or the build orders that you have, is the mix sort of up, down or sideways in the fourth quarter?

[Jack Allen:]

I am not sure I have that.

[Stephen Volkmann:]

Okay fair enough. I guess what I am trying to think about is, based on your adjusted EBITDA target for the fourth quarter, like almost the bottom half of that range is sort of down, quarter-over-quarter, and I guess I am trying to figure out, if there is something happening that would cause that or as you are just sort of trying to be a little bit conservative or why we would have a flat or even down EBITDA sequentially?

[Walter Borst:]

Yeah, its Walter. We hope that will be up sequentially, but there is a number of moving parts with Navistar as you know, and we do have some -- in some areas for example in SG&A, we do have some expenses that we have once a year, that typically fall in the fourth quarter. So while we hope to make progress in -- continue to make progress in most of the areas, there are some areas that are working against us a little bit as well. Military has been down this year as well. So those would be two areas that we are watching, even though on the SG&A side, we still expect to be up year-over-year in terms of our savings. I think that's what you should look at, but we have given you a $50 million range there, in terms of our EBITDA guidance.

[Stephen Volkmann:]

Right. Is military going to be down sequentially again?

[Walter Borst:]

I might have to take a look at that. It's another [ph] level?

[Stephen Volkmann:]

And then a quick follow-up, if you could just comment on your used equipment inventories, and how that progressed sequentially, and what pricing was looking like in that market, and I will pass it on?

[Troy Clarke:]

Walter is going to look up to the exact numbers for you. But in our -- our used truck inventory didn't go up in the quarter, as we had indicated that it would. But the market continues to be very strong for you, as truck sales is indicated by our sales being up 29% year-over-year, I would described pricing as being firm during the quarter. But with our new SCR units, that are performing well in the market, customers are getting improved quality and fuel economy, and as a result, we are working with a lot of customers to transition them to this new product, and that's resulting in this temporary increase in our used truck inventory. We manage this very closely as you can imagine, but the timing really is good, because the market is still strong, and the Diamond Renewed program that we launched, has got a lot of interest in the market, and we are using our own used truck reconditioning center to make sure that these vehicles are right, we are putting a very logical warranty associated with them, and we are very encouraged that we will move through this used truck bubble in a very efficient manner.

[Walter Borst:]

The number at the end of July and inventory was $265 million.

[Stephen Volkmann:]

Thank you.

[Operator:]

Thank you. Our next question comes from Joel Tiss of BMO. Your line is now open.

[Joel Tiss:]

Hey guys. How is it going?

[Heather Kos:]

Hey Joe.

[Joel Tiss:]

I just wonder if the parts margin improvement, are we getting to near where that is going to settle down a little bit, or do you think there is a visibility to get into the mid-20s over time?

[Walter Borst:]

That would be nice. That area is working extremely hard, and like every other part of the business, they have really been working to take structural costs out of the business. So if we can keep doing that, margins will continue to improve in this area.

[Troy Clarke:]

I think the other thing as we look forward to that is -- this is Troy by the way, is we really haven't, because of the warranty activity, we really haven't seen the parts sales related to our big bore engines. And the 13-liter is kind of still a relatively new product I think for the company, so I think we would anticipate beginning to see that effect, as the engines fall out of warranty, and our thought is, that that could have some upward pressure as well.

[Joel Tiss:]

Okay. Great. And just a quick one, maybe for Walter, that the other assets and liabilities had a $650 million negative swing, I just wonder if you can highlight a couple of the bigger chunks in there, just to get an idea what's in that category?

[Walter Borst:]

Yeah that's principally inventory related and parts, I mean that's the whole $600 million, but the kind of the year-to-date change, which I think was in the order of $290 million, if I am looking at the same line, or thinking about the same line you are --

[Joel Tiss:]

Right.

[Walter Borst:]

We did see used inventory increase about $100 million versus the end of last year, in follow-up to the prior question that we'd had. So I think that's what's principally driving that line item.

[Joel Tiss:]

Okay. Thank you very much.

[Operator:]

Thank you. Our next question comes from Ann Duignan of JP Morgan. Your line is now open.

[Ann Duignan:]

Hi good morning.

[Heather Kos:]

Hi Ann.

[Troy Clarke:]

Good morning Ann.

[Ann Duignan:]

Most of my questions have been answered, but I just wanted to circle back on the market share question, as I wander around different places around the United States, I am seeing more and more medium duty cab-over trucks, particularly some of the Paccar ones from their Dutch unit in Europe. Just curious if you're worried at all that your medium duty marker terminates the -- held back a little bit by this development and the trend towards more cab-over in driving?

[Jack Allen:]

Ann, this is Jack. I haven't looked at the data probably as close as you have, but cab-overs in the Class 6 and 7 market continue to be a single digit piece of the market. Certainly, there is a lot more cab-overs as you go down into the Class 3 and even Class 4 area. So I don't believe that that's a trend that's going to become more prevalent in the marketplace. I think its still just a good niche for intercity pickup and delivery.

[Troy Clarke:]

I would say, and this is Troy, an interesting note, just an anecdote over the course of this year, working with JAC, our Chinese partner, we have introduced Class 3, 4, and 5 cab-over trucks into the Mexican market, where there does appear to be more demand, and we have met with some success on it. I think this does create options for us in the future, if in fact, that trend starts to spread or comes to path.

[Ann Duignan:]

Okay. So you could take that joint venture -- those joint venture vehicles into the North America that you needed to or wanted to?

[Troy Clarke:]

Well, they wouldn't currently pass, I think the -- some of the regulatory requirements. But we have a very clear line of sight on what it would take to make that take place. Yes.

[Ann Duignan:]

Okay. My other questions have been mostly answered, so I will leave it there. Thanks.

[Troy Clarke:]

Thanks Ann.

[Operator:]

Thank you. Our next question comes from Andy Casey of Wells Fargo Securities. Your line is now open.

[Andy Casey:]

Thanks a lot. Good morning everyone.

[Troy Clarke:]

Hey Andy.

[Andy Casey:]

Looking at North American truck segment, you had a substantial improvement in Q3 versus Q2 on the EBIT line, and then if I look sequentially, you had roughly 93% incremental margin on a sequential $121 million revenue improvement. If I assume all of the warranty improvement occurred in that segment, it still drove around a 43% adjusted incremental. Can you talk about some of the subcomponents that changed outside, maybe the warranty in Q3 from Q2?

[Walter Borst:]

Yeah, one of the big ones continues to be structural costs, both in the SG&A area and in engineering; and most of that would be for the North America truck segment; but we did have higher volume as well, and I guess one that we sometimes don't talk about is, the improvements we have been making on the manufacturing side, and they continue to be on track, versus our $50 million to $60 million target for the year. Purchasing, you know, material savings is another area where we have been working hard to reduce our costs, and this year, in particular to a [indiscernible], the incremental costs we had related to adding SCR to our engines. So there is probably three, four, five areas, where we are seeing improvements in the North American segments.

[Andy Casey:]

Okay. Thanks Walter. And if I -- and just back on the structural costs, if I try to back in to the absolute dollar number, seemed like it stayed around $200 million in Q3 from Q2. So were there any offsets in other segments that may be mask the overall improvement, just on the North American truck?

[Walter Borst:]

I am not sure I am following your question.

[Andy Casey:]

Okay, I can follow-up with Heather offline on that. If we then turn to your performance in the quarter versus your longer term goals, and somebody had a cast-off comment, and I just want to come back to it. Your progress on warranty has been very good, and your -- in the quarter, you were below the 4% longer term goal, and then on the structural costs, you are getting within that 10% upper end of your longer term goal, relative to sales. Is the bulk of the gap, the EBITDA goal of 8% to 10% exiting next year, really now dependent on volume, or is there further cost reduction that you can do?

[Walter Borst:]

One of the areas that we hope to do quite a bit better on is in material costs over time. So one of the targets we have set out there, is to improve that by five points over time, and we are only part of the way through that journey at the current time.

[Troy Clarke:]

On top of that, we had previously announced the adjustment to our production capacity relative to the Huntsville plant. So we have referenced openly I think in the past, there is a $22 million kind of running start at the manufacturing savings that we get. Then Jack, I don't know if you want to comment, but I think on the sales thing, its just not units, its kind of the mix of sales and I don't know if you'd like to --

[Jack Allen:]

Just the severe service market because of the uniqueness of the vehicles and the complexity of those vehicles, traditionally have a higher margin. So as we do better in the severe service market, it will certainly -- the mix element of that will certainly help the overall EBITDA also.

[Troy Clarke:]

t those are kind of the components between what Walter commented and Jack did, if you kind of put those together, material costs, structural costs, big part of that is manufacturing, and then improved mix, those are kind of the three or four areas, almost equal I think in their weight, as we look forward to 2015. All have some upside, obviously all have some risks, but I think those are -- that's kind of at a 30,000 [indiscernible] we are looking at it.

[Andy Casey:]

Okay. Thank you very much.

[Troy Clarke:]

All right. Thank you, Andy.

[Operator:]

Thank you. Our next question comes from Andrew Kaplowitz of Barclays. Your line is now open.

[Andrew Kaplowitz:]

Good morning guys.

[Heather Kos:]

Hi Andy.

[Andrew Kaplowitz:]

Troy, can you update us on the Brazilian market a little bit more and maybe talk about the progress that you've made so far on taking costs out of the MWM Engine business. What do you need to see to get your overall global operations business to return to profitability, and how are you thinking about the business, versus your ability to achieve the 8% to 10% EBITDA margin run rate that you've talked about?

[Troy Clarke:]

Yeah Andrew, good question. So I think in the past we have referred to, we kind of have three pieces right now of your global enterprise. One of them is a very joint venture that we have in China around building engines right now with a company called JAC. The good news there is that's certainly not a drag, I think quite frankly -- and my hats off to our team over there working with the JAC guys, because it is very typical for a venture like this to lose money and absorb cash or consume cash for a period of time before it becomes positive; and I think Drew, the way we have approached that over there, we are really not experiencing that. So that's really not a drag, and I think as we go forward, not next year, but probably the next year, we will start to see some meaningful contributions; especially in light of the fact that this is a joint venture designed to make advanced emission requirement engines, and there is this huge push in China at this particular point of time, to get those engines into the field, given some of the issues and concerns that they have over there, with regards to air pollution and contamination. So that's kind of neutral to positive I think certainly going forward. The second piece of our business is, a pretty robust export business, primarily to Central America, and Andean Countries of Latin America. That actually kind of stalled a little bit on us earlier in the year, but seems to have picked up, and I think in fact strength in that area has offset some of the weakness that we have experienced in Brazil, which has taken us basically to kind of this breakeven-ish performance in the global side of our business, which is an improvement year-over-year. So that's the kind of thing, that I think with emissions regulations coming in, and certainly the reactivation of commodity-based economies in some of those Andean countries, we are optimistic we have really good share down there, we are a market leader, and I think we have the opportunity to look forward to more growth there. Brazil, really what we have is this engine business, and it’s a very well positioned engine business. We are kind of number one. We have a large market share. We are in a great position. The fact of the matter is, the whole economy is down, okay, and so what we have been forced to do there, is to maybe take a longer view and say, we need to implement some rather major restructuring and that it would significantly lower our breakeven point. We are in the process of doing that, okay, and we will wrestle that business to breakeven, over the course of the next six months or so. So I don't anticipate that it will be a drag on our efforts to get to the 8% to 10% EBITDA next year. When the market starts to come back in Brazil, this is a business that is very well positioned to -- because of the restructuring effort that we have done down there, I think to contribute and if it comes back next year, and there is some anticipation that it will after they get past their political season which takes place -- their election season, little bit later this year, then I think that this could be a little bit of insurance policy for us, and a contributor to the 8% to 10%. We are not counting on it to contribute a lot, as we put our numbers together at this point in time, and we are working very hard to make sure that its not a drag. But at the end of the day, it’s a good business. It has been a good business, its well run, got a great brand, have a good cost structure, we are making it even better.

[Andrew Kaplowitz:]

Okay Troy, that's helpful. And then just -- looking at the 8% to 10% goal a little bit more, at what point do you just adjust the pieces of your goal to what you actually see going in the market? For instance, maybe you give us a more specific structural cost target, considering how well you're doing there, and maybe you changed your market share forecast, or make it less specific, because it seems like if you're going to make your goal, maybe from my perspective it might be with a little less market share, but a little bit better cost for instance?

[Troy Clarke:]

Well I think what we will do is, give us a chance to get through to fourth quarter here, then we will give you a good wrap-up for I think the 2014 -- through 2014, and then if there is any kind of -- I am sure, there will be the need for clarification, if we say maybe resetting some of those parameters, and we have run sensitivities around those, please be assured of that. But I think at this point in time, we are still very confident. There is a lot of buttons we have yet to push. We are making progress, again as Jack indicated, in some areas that exceed our expectations. We are confident the market share is coming, and the mix is improving. So give us another quarter or so to finish up our -- executing the plan for this year and then we will give you guys some more insight into 2015 this week, as we go forward.

[Andrew Kaplowitz:]

Okay. Thanks for that Troy.

[Operator:]

Thank you. Our next question comes from Brian Sponheimer of Gabelli and Company. Your line is now open.

[Brian Sponheimer:]

Hey guys. Thank you for having me on.

[Troy Clarke:]

Hey Brian.

[Brian Sponheimer:]

Just a few for me, and I am trying to frame just this $1,300 per engine cost reduction, if we are looking for the 2015 certified engines. Let's say volume is neutral, and you're shelling roughly 20,000 this year, are you calling out at least $26 million opportunity next year on the material cost side?

[Walter Borst:]

You're referring to the $1,400 that we plan to take out of the 13-liter, I think that's directionally correct.

[Brian Sponheimer:]

Right, okay. All right its $28 million on 20,000 engines give or take. If I am thinking about your used inventory and your used prices, how dependent are you on bonus depreciation in Section 179, getting renewed to kind of work some of that used inventory through the system in the last few months of the year?

[Jack Allen:]

We are really not counting that. That would be a -- in addition to probably have an end of the year sales surge. But we haven't baked that into our plans.

[Brian Sponheimer:]

All right. And just -- Walter, if I am thinking about some of the restructuring that you've done, typically Navistar has had a significant cash outflow during the first and second quarters of your fiscal year. Should there be any change maybe from a working capital basis, given this renewed company with all of your structural changes, and how cash burn takes place over -- from a seasonal perspective?

[Walter Borst:]

I think you could still expect the first quarter to be from a cash flow perspective than let's say the fourth quarter, just because of the number of operating days in our first quarter, which kind of covers that November to January time period, is lower. So you should expect I think that, that will impact our cash flow from a seasonal perspective, but our obviously here is to improve our quarterly results, and so if we can continue to do better year-over-year on EBITDA, then the change in working capital in the first quarter won't be as significant as what you had seen before. I am not sure whether the second quarter has historically been a significant negative cash quarter. I kind of think it more as flattish, is what I have seen in the time I have been here, and again, we hope to improve on that in the future.

[Brian Sponheimer:]

All right. How are you thinking about the balance sheet? You got about $2.1 billion in net debt and certainly the healthcare liability is out there, and will likely continue to be so, until we see some significant increases in rates?

[Walter Borst:]

Yeah, as I mentioned in my prepared remarks, we are kind of moving through our financial milestones, and ultimately, we want to get to cash flow positive, and then we will be able to delever the balance sheet. But in the short term, we continue to be focused on liquidity in minimizing the cash use and improving our year-on-year quarterly results. So we have done a great job I think this year of maintaining our liquidity position, while extending our maturity of our debt. So those were our goals for this year, and as we get to cash flow positive on a sustainable basis, we will look to delever the balance sheet over time.

[Brian Sponheimer:]

All right. I agree with that. Great job guys. Thank you.

[Walter Borst:]

Thank you.

[Operator:]

Thank you. Our next question comes from Adam Uhlman of Cleveland Research. Your line is now open.

[Adam Uhlman:]

Hi guys. Good morning.

[Troy Clarke:]

Good morning.

[Adam Uhlman:]

I was wondering if you could talk about the pricing levels on trucks that you have in the backlog right now? Whether or not, we should be expecting that to get better or worse relative to the shipments that we had this quarter? I know its tough with mix and everything else in there, but -- actually how you're thinking about that, its actually relative to your market share goals going forward?

[Jack Allen:]

We don't see a significant change in the fourth quarter compared to what we have been experiencing. Pricing in the market has been fairly firm.

[Adam Uhlman:]

Okay. Got you. Thanks very much.

[Heather Kos:]

Thank you.

[Operator:]

Thank you. And our final question comes from Steven Fisher of UBS. Your line is now open.

[Steven Fisher:]

Great. Thanks very much. You guys cited a 54% increase in your backlog year-over-year. To what extent you have long-dated orders in that backlog that gives you some visibility out to 2015 already?

[Jack Allen:]

We don't count orders in our backlog that would extend beyond 12 months. So that's kind of our first general rule, not sure if that's an industry rule, but that's what we count. So that would be one thing, Steven. So we do have orders that extend into next year, but it’s a very past -- I am assuming, you mean past January, but it’s a very low percentage of what's in our overall order book.

[Steven Fisher:]

Okay. And then obviously some great progress there on the structural costs. Now that we have had a couple of quarters, where you've raised your targets there, what would you say has been the biggest driver of the upside surprise there, or is it maybe more timing dynamic, where you're just getting the benefits faster than expected?

[Walter Borst:]

I just think really everybody has rolled up their sleeves and embraced our lean culture here. And we have asked the organization to think hard about spending money and not spending where its not needed, and the organization has really responded. We are improving our processes and implementing lean, not only in the manufacturing environment, but in the office environment as well, and I think that has given us some good upside versus where we surely expected the year initially to fall out.

[Troy Clarke:]

This is Troy, I would agree with Walter. I think its really a function of broad-based engagement on a handful of basic lean concepts. The most basic of which is, we have gone to great efforts in the last couple of years to make our -- all elements of performance in our operation far more visible to everybody, and the things that we do to review performance and get people engaged in the forecasting process, reaches really far down into the organization and we have got a couple of thousand people kind of all aligned around how we look at where we spend money, and if it isn't satisfying a customer or satisfying a shareholder or investing in the future, we are really just challenging ourselves and questioning if that's the kind of things that we should be doing. Again, the great thing is, its just not myself or Walter, Jack, it’s a couple of thousand people who are doing that every day, and have been invited into that process, in a very motivating and positive way by the way. You could be surprised if you visited our headquarters, it doesn't feel like there is a Draconian effort to reduce costs. There is a lot of energy and excitement around people finding new and better ways to do things and discovering waste as we have defined it in our lean process, and taking it out. So its one of those times in any effort, but certainly some people experiencing in their career, where you can't wait to get to work every day, because there is just more good news coming at you, and sometimes it's $100, sometimes it's $1,000. We are fortunate sometimes when its several million dollars, but everybody is engaged, everybody is involved, that's the Navistar that we have created and that we are all excited to be a part of.

[Steven Fisher:]

Sounds good. Thanks very much.

[Operator:]

Thank you. And at this time, I'd like to turn the call back to management for any closing comments.

[Troy Clarke:]

Hey, I wanted to just thank everybody for your participation in today's call. Certainly, this is -- we are treating this as a milestone inside of our company. It’s the first time we have had this type of news to report since 2011, but certainly as a leadership group, and I think the entire Navistar team recognizes, this is just another step in the journey; a journey that we keep pushing forward, and we look forward to sharing with you in the fourth quarter, as it comes to us.

[Heather Kos:]

Thank you everybody and we are available for questions after the call.

[Operator:]

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a wonderful day.