Allison Transmission Holdings Inc (ALSN) 2012 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's third-quarter 2012 earnings conference call. My name is Nancy, and I will be our conference operator for today. At this time, all participants are in a listen-only mode. After the prepared remarks, the management from Allison Transmission will conduct a question-and-answer session, and conference participants will be given instructions at that time. As a reminder, this conference call is being recorded. I would now like to turn the conference call over to Mr. Dave Graziosi, the Company's Executive Vice President and Chief Financial Officer. Please go ahead, sir.

Thank you, Operator. Good afternoon, and thank you for joining us for our third-quarter 2012 results conference call. With me this afternoon is Larry Dewey, Allison's Chairman, President, and Chief Executive Officer. As a reminder, this conference call, webcast, and the presentation we are using this afternoon are available on the investor relations section of our website, www.AllisonTransmission.com. A replay of this call will be available through November 5.

As shown on page 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These statements may often be identified with words such as expect, anticipate, believe, or similar indications of future expectations. Although we believe that such forward-looking statements are reasonable, we cannot assure you that any forward-looking statements will prove to be correct. These forward-looking statements are subject to known and unknown risks, uncertainties, and other factors, as well as general economic conditions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those that we express today. Additionally, let me refer you to our third-quarter 2012 results press release and our March 15, 2012 prospectus, which was filed with the SEC, where you will find factors that cause actual results to differ materially from those forward-looking statements.

In addition, on page 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. The presentation of this additional information is not meant to be considered in isolation or as a substitute for or superior to measures of financial performance prepared in accordance with GAAP and should not be considered as an alternative to the GAAP measures. You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached as an appendix to the presentation and to our third-quarter 2012 results press release, both of which are posted on the investor relations section of our website.

Today's call is set to end at 5.30 Eastern Time. In order to maximize participation opportunities on the call, please limit your questions to one with one follow-up question. Now I'll turn the call over to Larry Dewey.

Thank you, Dave. Good afternoon, and thanks, everyone for joining us today, particularly those of you on the East Coast. Hopefully, you are battened down pretty well for the weather that is coming at you.

Despite a year-over-year decline in third-quarter net sales largely attributable to the previously considered cyclicality of the North American energy sector's hydraulic fracturing market, diminished North America On-Highway vehicle production schedules, and reduced US defense spending, Allison continued to demonstrate strong operating margins and cash flow while investing in growth opportunities. During the third quarter, we also maintained our commitment to prudent capital-structure management by refinancing approximately 50%, or $850 million of Allison's Senior Secured Credit Facility Term B-1 loan due in 2014, repaid $105 million of debt, and paid a quarterly dividend to our shareholders. Consistent with our previous 2012 guidance, we expect no meaningful relief from the third-quarter North America end markets challenges in the fourth quarter, typically Allison's slowest quarter due to seasonal production downtime taken by many of our customers.

Please turn to slide 4 of the presentation for the call agenda. On today's call, I'll provide you with an overview of our third-quarter 2012 performance, including sales by end market. Dave will review the third-quarter 2012 financial performance, including adjusted EBITDA and free cash flow. I'll then provide an overview of our end markets and wrap up the prepared comments with updated full-year 2012 guidance prior to question-and-answers.

Please turn to slide 5 of the presentation for the Q3 performance summary. Net sales decreased approximately 14% from the same period in 2011, principally driven by decreased demand for North America Off-Highway products relative to the elevated demand we were experiencing in the prior-year period driven by the strength in natural gas pricing. The North America On-Highway Military and Service Parts, Support Equipment and Other end markets also experienced modest declines, which were partially offset by price increases on certain products. Our outside-North America net sales were in line with the prior year due to growth in China offsetting weakness in European end markets.

Gross margin increased 60 basis points from the same period in 2011, principally driven by improved manufacturing performance, favorable material costs, and price increases on certain products. Adjusted net income decreased $31 million from the same period in 2011, principally driven by decreased gross profit, $12 million of certain technology-related license expenses, and increased cash interest expense as a result of debt refinancing and repayments, partially offset by lower global commercial and engineering research and development spending activities. Adjusted free cash flow decreased $56 million from the same period in 2011, principally driven by decreased net cash provided by operating activities and increased capital expenditures attributable to increased product initiative spending and investments in productivity and replacement programs. Consistent with our previous 2012 guidance, we completed the expansion of our India facility during the third quarter.

Please turn to slide 6 of the presentation for the Q3 sales performance summary. North America On-Highway end market net sales were down 5% from the same period in 2011 and below expectations due to increased deterioration in commercial vehicle production. During the third quarter, we experienced lower demand for Rugged Duty Series and Highway Series models. These reductions were partially offset by increased sales of Pupil Transportation and Shuttle Series, as well as the Motorhome Series models. North America Hybrid-Propulsion Systems for Transit Bus end market net sales were up 7% from the same period in 2011, principally due to the timing of orders. As we noted during our second-quarter conference call, second-quarter 2012 net sales were down 55% from the same period in 2011, principally due to [intra]-year movements in the timing of orders.

North America Off-Highway end market net sales were down 71% from the same period in 2011, principally driven by lower demand from hydraulic fracturing operations due to weakness in natural gas pricing. Third-quarter net sales were also below expectations due to further deterioration in hydraulic fracturing rig production and utilization rates, despite some improvement in natural-gas pricing. Military net sales were down 9% from the same period in 2011, principally due to lower wheeled and tracked products requirements, consistent with reduced US defense spending. Outside North America On-Highway end market net sales were flat with the same period in 2011, reflecting strength in China being offset by weaker environments in Europe and Latin America. Outside North America Off-Highway end market net sales were down 8% from the same period in 2011, principally driven by weaker mining sector demand, partially offset by stronger demand from the energy sector. S

ervice Parts, Support Equipment and Other end market net sales were down 10% from the same period in 2011, principally driven by lower demand for global off-highway service parts and reduced support equipment sales commensurate with decreased transmission unit volumes. Now, I'll turn the call over to Dave Graziosi.

Thank you, Larry. Please turn to slide 7 of the presentation for the Q3 financial performance summary. Given Larry's comments, I'll focus on other income statement line items and adjusted EBITDA. Selling, general, and administrative expenses decreased $5 million, or 5%, from the same period in 2011. The decrease is principally driven by lower global spending activities, partially offset by the elimination of favorable 2011 product warranty expense adjustments. Engineering research and development expenses increased $4 million, or 12%, compared to the same period in 2011, principally due to $12 million of certain technology-related license expenses from the execution of a co-development agreement with Fallbrook Technologies and a partial contingent license exclusivity payment to Torotrak, partially offset by the timing of product initiative spending.

Interest expense net decreased $23 million, or 36%, from the same period in 2011, principally driven by an $18 million decrease in mark-to-market expense for our interest rate derivatives; $13 million of lower interest expense as a result of debt repayments and purchases, partially offset by higher interest rates; and amortization of deferred financing fees related to a refinancing of our senior secured credit facility; and the effectiveness of [new] interest rate swaps at higher interest rates. Other expense net decreased $2 million from the same period in 2011, principally driven by favorable foreign exchange; higher gains on derivative contracts; and a decrease in premiums and expenses related to redemptions of long-term debt, partially offset by the impairment of technology-related investments and decreased grant-program income. Income tax expense for the quarter was $17 million, resulting in an effective tax rate of 34.6%, versus an effective tax rate of 32% for the same period in 2011. The effective tax rate increase was principally driven by higher discrete activity than the same period in 2011.

Adjusted EBITDA, excluding technology-related license expenses for the quarter, was $172 million, or 34.8% of net sales, compared to $193 million, or 33.7% of net sales, for the same period in 2011. The decrease in adjusted EBITDA was principally driven by a decreased gross profit, partially offset by lower global and commercial and engineering research and development spending activities. The increase in adjusted EBITDA margin, excluding technology-related license expenses, of approximately 110 basis points was principally driven by the previously referenced gross margin improvement and lower global commercial and engineering research and development spending activities.

Please turn to slide 8 of the presentation for the Q3 cash flow performance summary. Given Larry's comments, I will focus on specific cash flow activity during the third quarter and provide some fourth-quarter 2012 guidance. Allison continued to demonstrate a solid re-occurring cash flow conversion rate during the third quarter despite weakening sales demand, inconsistent commercial vehicle production schedules, and labor negotiations planning. As Larry mentioned, we refinanced $850 million of our 2014 Senior Secured Credit Facility Term B-1 loan during the third quarter. Early this month, we refinanced an additional $300 million of the Term B-1 loan, resulting in a remaining August 2012 -- 2014 maturity of $500 million. These latest refinancing activities, together with other refinancing transactions completed in 2011 in the first quarter of 2012, have better aligned Allison's debt maturities with its over the cycle free cash flow and longer-term net leverage targets.

During the quarter, we also repaid $105 million of debt and paid a dividend of $0.06 per common share. Allison ended the quarter with $82 million of cash, $372 million of revolver availability after letters of credit, and net leverage of 3.89. Looking forward to the fourth quarter, we plan to pay our quarterly dividend of $0.06 per common share. We will announce the record date and payment date of the dividend by press release once determined. Now I'll turn the call over to Larry Dewey.

Thank you, Dave. Please turn to slide 9 of the presentation for the end markets commentary. Consistent with our second-quarter conference call, full-year net sales guidance were -- consistent with our second-quarter conference call, we're maintaining a cautious approach to the full-year net sales guidance given heightened global economic uncertainties. Accordingly, I would highlight the following for our end markets. North America On-Highway, we expect full-year net sales growth of 8%, implying a year-over-year reduction in the fourth quarter. We attribute the fourth-quarter weakness to the stalled market recovery, driven by heightened uncertainty and diminished commercial vehicle production forecasts.

North America Hybrid-Propulsion Systems for Transit Bus, we expect a full-year net sales reduction of 16%, implying a year-over-year growth in the fourth quarter. We attribute the fourth-quarter strength to the timing of orders given no improvement in this sector of municipal spending. North America Off-Highway, we expect a full-year net sales reduction of 43%, implying a year-over-year reduction in the fourth quarter. We anticipate no meaningful relief from the North America energy sector hydraulic fracturing markets challenges, given forecasts for continued softness in rig utilization rates attributable to weakness in natural gas pricing and increased levels of surplus or underutilized equipment. Military, we expect a full-year net sales reduction of 2%, implying a year-over-year reduction in the fourth quarter, principally driven by reductions in US defense spending.

Outside North America On-Highway, we expect full-year net sales growth of 1.5%, implying a year-over-year reduction in the fourth quarter. We attribute the fourth-quarter weakness to heightened economic uncertainties, diminished commercial vehicle production forecasts, and continued softness in the European end markets. Outside North America Off-Highway, we expect full-year net sales growth of 27%, implying year-over-year growth in the fourth quarter. We anticipate fourth-quarter demand will reflect the sector trends we experienced in the third quarter. Service Parts, Support Equipment and Other, we expect a full-year net sales reduction of 1%, implying a year-over-year reduction in the fourth quarter, principally driven by lower demand for global off-highway service parts and reduced support equipment sales commensurate with decreased transmission unit volumes.

Please turn to slide 10 of the presentation for the full-year 2012 guidance update. Allison expects 2012 net sales to decline in the range of 2.5% to 3.5%, and adjusted EBITDA margin, excluding technology-related license expenses, in the range of 33.5% to 34%, and an adjusted free cash flow in the range of $350 million to $380 million, or $1.88 to $2.04 per diluted share. Capital expenditures are expected to be in the range of $120 million to $130 million, which includes maintenance spending of approximately $62 million, and are subject to timely completion of development and sourcing milestones for new-product programs. Cash income taxes are expected to be in the range of $12 million to $15 million. This concludes our prepared remarks. Nancy, please open the call for questions.

Thank you, sir.

(Operator Instructions)

Ann Duignan, JPMorgan.

I wanted to start out with your gross margin. It was pretty impressive given the sales decline. Larry, maybe you could tell us a little bit about what specifically you have done in the manufacturing environment and where you have been able to make cuts that allowed you to keep the gross margins as high as they were?

I think there were probably three things that came into play. One was certainly, we have seen some relief on materials. And in the manufacturing arena, we continue to press on improving the efficiencies. One of the measures we speak to quite frequently is hours per unit, and the guys have continued to do a nice job there, some of which is tied to that what we call our sustainment capital, where we'll get equipment that allows us to capture some additional labor productivity, as well as driving out some of the -- I will call it operational work path, i.e., industrial engineering-type efficiencies. And then the final thing, I think year-over-year, there was a net change in the warranty cost I believe Dave referenced in his comments.

Okay, and on the lower material cost, will you be required to give those back, or partially give those back, to your OEM customers going forward?

We do have the supply agreements, as you point out. And we established baselines for each of those relative to a material cost. It would really depend on which baseline that we established, what the timeframe of that was, and then how the current ones, while lower than what they spike to, how those play out. I believe as it stands now on balance, we are still above the baseline. But I guess I'd look to Dave here for any additional --.

I would say in going forward certainly for next year, we would not expect a significant change in terms of the give-back, if you will, or pass-through.

Okay, so these gross margins you think despite revenue headwinds should be sustainable. Is that the message we should take away?

We have talked several times before in terms of sustainability with the various programs, and Larry obviously alluded to a few. We also have the continuing dynamics of the demographics on the hourly side in terms of retirement eligible, et cetera. So those issues combined certainly will help. That being said, I think as you know following the sector as closely as you do, there's certainly going to be some challenges out there in terms of supply chain going forward given the relative tightness in certain regards. I think as you balance all that out, we feel good about where we are from a margin standpoint.

Okay, and then a quick follow-up. As we head to the end of year and into 2013, which of the end markets are you most concerned about as it stands today, with the limited visibility that you have? But which one are you concerned most?

I am a full-time ponderer. So you look at the Military, that's moving in the direction that we talked it was.

Yes.

North America On-Highway, the question is when are we going to get back on track for a more stronger-type recovery. Obviously, we're seeing some recovery, but it's not at the level people thought, and the issue is when are we going to get back on track with that. The energy sector continues to be challenged in the fracking area, especially in the natural gas sector. You're seeing people into the liquids, but as we've indicated, that is not as equipment-intensive as the gas in the shale plays. So we will watch that.

I think you're seeing some improvement in the pricing, and you are certainly seeing a lot of activity that will drive a fundamental baseline demand, whether it's vehicles, whether it's power plants, whether it's the dozen or so applications to export LNG. As some of those processes presumably are improved, that's going to change some of the dynamics. I read something recently it said that it could add as much as 20% to the demand here in North America. We are seeing the growth for our equipment outside of North America, as we indicated, in the energy sector. Non-NAFTA, you got the European situation, but we are making some nice gains in terms of the releases. We feel we are solidly positioned there as those markets continue to develop. I would say if you had to pick two, I would say we are watching the energy sector here in North America very closely and also the commercial On-Highway business.

That make sense. Okay, in the interest of time and the weather, I will get back in line. Thanks.

Jerry Revich, Goldman Sachs.

Larry, can you talk about the levers that you are exercising to right-size the cost structure for -- you're fourth-quarter outlook is for roughly a 10% cut in production, and judging by the OEMs, that type of environment is going to continue through call it first half of '13. So I'm wondering if you could step us through any changes you're making to the cost structure relative to the third-quarter production rate?

There's a lot of uncertainty in terms of -- and you're right, there -- folks certainly aren't sounding a lot of optimism. Although in fairness, we have had some movement in both directions here with some of the schedules, some cuts. And now people are looking to say okay, nobody really knows, and they're trying to sort through that. We are certainly watching to make sure that number one, we are not tying up a lot of cash in inventory. We're certainly -- we did not add heads, as I indicated in previous calls. When we saw what appeared to be some schedule increases, we actually in our plans weighed in overtime days. So as a result, as the volumes haven't necessarily materialized in some of the on-highway sectors to the level we thought, we have been able to eliminate overtime days, and we don't have an overhang of staffing, which has been helpful.

We are probably, depending on some of the OEMs plans, going to look at how we balance our rates. Do we change the line rate, or do we take intermittent downtime? Those are tools that we've used historically. We feel pretty comfortable with that. Obviously, on the purchase side, while the volumes aren't recovering as fast as what everybody thought, they are still up. And subject to the purchase agreements we have, we think we are pretty solid there.

So those are some of the things that we're doing to make sure that we have avoided creating overhangs and making sure that we watch our expenses. And we have a culture here. We see how things are playing out. We have a lot of initiatives, and we are very clear about prioritizing those. We talk about it like a family budget. You have ideas of what you'd like to do, and depending on how the income comes in, then you adjust those projects you tackle based on what's going into the bank account.

So it sounds like you still have room from an overtime standpoint to cut the hours per person relative to the 10% top line cut you're looking for for the fourth quarter?

Yes, we think we have certainly taken the overtime days out. And now we're looking at how we think the inventory is going to play out versus potential -- we could take some days out of the schedule with some scheduled downtime. We've done that. We have already done a little of that this year, and we may do some more of that in the fourth quarter.

And thinking about the R&D and SG&A outlook for the next 12 to 18 months, can you step us through your framework, where you are on the major projects? Could we some scale-down in R&D? And if you don't mind, touch on how we should be thinking about [pricing metal] material costs on the new model year trucks for North America On-Highway? Thanks.

It's Dave. A couple things in terms of the run rate on the engineering and research and development. As we've talked before, the TC10 metro transmission product, as well as the H 3000, those programs are starting to come to a bit of an end in terms of the development effort. So that will move into 2013. Certainly, post-2013, we would look to start scaling back a bit at that stage. As Larry and I have mentioned before, certainly the concept of backfilling the new product development pipeline is certainly we're focused on. At this stage, we don't have necessarily something to fill in come 2014. But as we look beyond that, into the '15, '16 timeframe, that's something we'll put some more energy into in terms of scheduling. That being said, as you think about the products, both the TC10 and H 3000, as we talked before, we expect those products both to have relatively slow ramp, as consistent with the past in terms of commercial vehicle sector. So I would not spend a tremendous amount of time focused on those in terms of run rates for '13 at this stage. We are still formalizing our launch timing there and working with various OEMs on those programs. So we will leave that to be announced next year when those plans are firmed up.

Thank you.

Andy Kaplowitz, Barclays.

Larry, can you talk about your success in penetrating the emerging markets in really China, as you highlighted, in the non-North American On-Highway market? It's been a source of strength for you guys. It's been able to offset Europe. How much is China now of that business? And is that sort of success you have had sustainable going forward?

I'll let Dave speak to the percentages there. But let me just talk about the methodology. We established ourselves -- well, actually, we have been there in a limited way in the off-highway sector. However, as China has gotten more involved -- and I think they just finished up a bid for a lot of areas to be developed for energy, a number of -- in fact, I think, in every case a state-owned company won the bid here recently. But nonetheless, they've certainly gotten more aggressive, and as they have done that, our leadership position, we would like to say in the energy sector, for the transmissions in that sector is recognized. And as a result, we have been gaining a lot of business through the Chinese OEMs in the off-highway energy sector. We're also starting to get more business in the mining sector, although we have been there through Terex, North Hauler for a number of years, decades. But now some of the other companies, Sany et cetera, have been starting to release the Allison. In the on-highway space, the bus activity continues to be strong. It is a competitive business with Voith and Zed F certainly trying to claw their way into that market. We feel good about the position we have, and we're going to continue to work to earn a very good portion of that business.

And then we are branching out in the on-highway space into the truck sector. We've got some business in fire trucks. That's come a little slower. We've got good releases there, but the volumes have been a little slower. But we are broadening those releases into construction and other emergency vehicles. China's been a good story for us, and it's been strong this year. We feel good about Europe, other than the fact that -- we feel good about our release activity. Let me put it that way. The market itself is very soft, but we continue to gain releases. We continue to position ourselves well, and when that market does come back, we think the wind will catch the sales that we put in place there as well.

Jerry, it's Dave. In terms of our China business, figure based on our guidance here, it's roughly about 8% of our consolidated sales out of the China business Larry mentioned in terms of releases. And then our standard investor relations presentation, the truck releases we very much focused on, as you know, given typically the entry point with bus. But as of the end of last year, we had about 72 truck releases. We're certainly expecting this year at least a 25% growth in terms of truck releases by the end of the year. So again, a lot of the inroads that Larry mentioned in those efforts continue to accrue to Allison's benefit and we'll continue to pursue the balance of projects that we have out there.

Okay. That's helpful, guys. Larry, if I could follow up on that non-North American Off-Highway market, you do model actually a slight sequential improvement in the fourth quarter. We are all well aware of the pressure that is on mining CapEx globally. So could you reconcile that? Is that you're gaining share in China? Is that what you're counting on as you go forward?

There's some activity there. Frankly, there's some activity in Russia that we've got going on that we haven't had historically. And there's -- we're starting to see more activity out of Latin America as well. All of those end markets, I -- we certainly do see folks looking at what that sector -- it's a mixed bag. I would say we have gotten some reductions from a couple of our OEMs, but with the new OEMs we have added, net-net, we are forecasting where we have indicated.

Okay, Larry. I appreciate it. Thank you.

(Operator Instructions)

David Leiker, Baird.

This is Joe on the line for David. If I did the math right, looking at what you are expecting for your Q4 North America On-Highway business, it looks like about a 15% sequential decline. I'm wondering, can you bucket that between what the industry is expected to do versus one of your larger customers starting to have share gains in their medium-duty product line? Share losses, excuse me.

We don't talk individual OEMs, but certainly, the numbers we had for the top OEMs is available from our public reporting. I would tell you potentially the one that you are referring to, that volume is down slightly this year, but it's been certainly absorbed by other OEMs. To your point, as we think about our guidance versus the broader market, I would just say without being -- getting into specifics, we prepared it from a bottoms-up approach with OEM input, as well as various forecasting sources, as we've talked about. Without endorsing any of those, I would certainly say that we believe our approach is prudent. I would also call your attention to the fact that as we recall, not many had accurately forecast the Q3 results in terms of production days and schedules. With that in mind, we certainly took that into account in Q4. And I would tell you more or less, the mix is consistent with our full-year book of business at this point.

So the main take-away there, if I can summarize is that customers might move away from OEM [a], but you are still capturing their transmission business?

I think that's a fair assessment.

Okay, great. And then if I look at the North America energy business, or Off-Highway business, it looks like based on full-year expectations, that business has seen a flat sequentially. The other big transmission player in the market was talking about a pick-up in, call it Q2 of 2013. Do think we are in a position here where volumes are pretty much flat for the next several quarters? And is that timing? So like a summer 2013 pick-up in line with your expectations and when your volumes could start to inflect in that business?

I think we've overall had -- certainly read some of the same guidance you are referring to. I would say there's differences amongst component suppliers, given order cancellation timing, et cetera. That being said, we have certainly availed ourselves as much as possible to inventory numbers in the field, as well as rig counts and utilization rates that Larry referencing. Given all of that input, again, did a bottoms-up approach for our Q4. At this stage, we are not providing 2013 guidance and are watching closely, as well as you are, all the data points that are out there. But I think the fact remains that based on industry input, with natural gas pricing being at the current level, we're certainly shy of that 4 to 4.50 range that's required to generate increased utilization rates. We're certainly in the same position everybody else is, waiting for those gas-price economics to improve.

Okay, great. I will leave it there. Thanks, guys.

Brett Hoselton, KeyBanc.

First question, broadly speaking lowered your sales guidance by 4% to 5%, maintained your EBITDA and your free cash flow guidance. What I'm wondering is normally you'd see a little bit of leverage there. You've obviously been able offset that some way. Can you characterize some of the major offsets?

As we pulled the numbers together and certainly took this approach to our Q3, or second-half guidance, relatively conservative in terms of some of the margin pull-throughs for no reason other than to Larry's earlier commentary in terms of running this facility and production rate, being careful not to get ahead of ourselves. And frankly, we have taken same approach to the fourth quarter. There are a lot of moving pieces in the fourth quarter, as we mentioned here on the call, probably not all of them, as well in terms of the variability. The uncertainty in our view is very high, certainly than it was at this time last year. We have labor negotiations underway as well. So all those issues are certainly in the mix as we think about the fourth quarter and trying to take more of a prudent approach in terms of margins.

Switching gears, looking at cadence of sales into the fourth quarter, a continuation of what Joe was asking about here. But looking at some of the other sectors, the non-North America Off-Highway, you're seeing a notable step up in terms of sales going into the fourth quarter. It hasn't necessarily seemingly been the case in the prior two years. Is that just a continuation of your growth strategy? Or is it seasonality that was masked the previous years?

I don't think it's seasonality. I think it's a matter of gaining. We have been working some accounts and we were able to crack them. Particularly in China, there has been some nice volumes begin to materialize there, which is what we've said all along when we talked about -- even going back to the IPO. We said three things about the energy sector. Number one, we said perturbations in North America. Number two, increasing demand driven by a variety of factors, utilities, vehicles, et cetera. And then the third thing we said is that when you look at our energy business, within the total Off-Highway end markets, if you look at the energy end market, we've got a component maybe that some do or some don't, and that is the non-NAFTA piece of that. That was going to grow, and that was based on what we understood to be the plans of some of those OEMs to release us. That has happened, and so it's kind of a -- albeit at lower volumes, it's kind of a light-switch thing. We're selling nothing, and then you start selling something. So that accounts for a step up. And they will continue to, assuming the product performs like we believe it should, we will continue to make inroads there.

How do we think about the Parts and Support and Equipment section of the business? As I look at the sales in the first to the second to the third to the fourth quarter, give or take $5 million to $10 million decline in each of those quarters sequentially, and then it looks like it's going to continue into the fourth quarter here. So how should I think about that business in terms of the go-forward?

Several things that are in there. It's -- gathers it all up. First thing is service parts, and you can think about that for both On-Highway, as well as Off-Highway. North America On-Highway, solid performance, fairly stable. Non-NAFTA Service Parts for On-Highway is growing. They're parts are growing as a result of the growth in sales we have had over the years here as we have continued to build that volume. The significant downside, I guess, the largest single one, is tied to the North America energy sector. And as everyone was running the heck out of their equipment, they were buying a lot of parts to make sure it could keep going.

As they've idled a fair amount of equipment, while they are doing some refurbishment, and we know that for a fact, they do have a lot of equipment as you all know from the studies you guys do, that is idle. And when it's idled, beyond -- they are refurbing some, so that's a good sign. They're not just completely sitting on their hands. But they're not refurbing at all, so there is some equipment that sits idle, and they won't repair that until they have a need for it. That's caused a drop-off. And then the other thing is as OEM -- the other piece that's in the parts business of significance, is the, what I will call, the first installation, or we call it support equipment. And that's really tied our ratios right to the unit new unit sales. And as OEMs have reduced their schedules, we don't sell as many support and equipment parts there.

Thank you very much, gentlemen.

(Operator Instructions)

Rob Wertheimer, Vertical Research Partners.

I hope I didn't miss something simple, but it seemed as though on that earlier question you lowered the revenues by whatever, 5%, and you kept the margins the same and also the cash flow the same. Am I missing something, or could you help bridge the gap between that lost revenue dollars, same margins, and same profit?

This is Dave. Couple things, as we approach -- and we're obviously building time here as a public company -- our approach in terms of EBITDA margin is typically to be more conservative on the ultimate pull-through there. That's even more so the case with fourth quarter, given the moving pieces that we have. As Larry mentioned, still making decisions on shutdown days. We have labor negotiations underway. You have OEMs continuing to move around their schedules. Frankly, inventories are high, their inventories, it would appear in certain respects. In the field, we have assumed various things are going to be happening this quarter. And given the mix that we talked through in terms of guidance, when you pull that all together, the margin guidance that we have for the fourth quarter, which is typically one of our weakest ones, is ultimately reflected there.

As we are working our way through the quarter, having almost one month under our belt, we feel pretty good about where we are at from a guidance standpoint there. We will see how the balance of these two months go, which doesn't seem like a long period of time. But given the amount of I would say uncertainty around the market, we are taking a -- and continue to posture ourselves in a more conservative way. The cash flow, as we thought about inventory level certainly coming into the fourth quarter, some of that will ultimately fall out of the labor negotiating process in terms of how we end the quarter, as well as OEM take rates and whether they make any adjustments. As we talked about, going into the third quarter, there was a heightened level of adjustments that had been made. We've seen the rate of some of those slow down a bit as we exited the third quarter. From that standpoint, that feels a little bit better. That being said, I think that as is typical, they're going to wait till they get further in the quarter to make some final adjustments for year-end. That's how we ultimately came up with the guidance that you see there.

Okay, great. We talk tomorrow, so maybe we can go through some of the arithmetic. One other question, it looks like the Off-Highway North America has gotten pretty bombed out. Are you able to say how much of that, if any, was new build? Are there any new build sales in there? And do you think that run rate on after-market has dipped below -- was there any de-stock? Was there any put off? Is the run rate in the after-market running with utilization, or has it dipped below it temporarily? Thanks.

I would say first off, to the first part of the question, there is certainly rigs being built. We know that for a fact. Obviously at a reduced number compared to last year and compared to the blow-out, I think all-time record in fact, sales in the first quarter of this year. Clearly, that has stepped down. Relative to the service parts, I would say that we're probably -- and this is more of a feel, because we ask people, and it's very hard to get your arms around total after-market. But I think we feel like we have gotten to -- at least based on the current level of activity, diminished though it is -- we think it's stable. We don't think its running well below what they need.

Now clearly, if activity picks up, they're going to need to get, to the extent those rigs need some work that they've got parts, they're going to need more parts. But that will be a little more gradual as they redeploy those rigs. We think right now the after-market is probably in balance with the amount of activity that is going on. Some of those rigs that are being refurbed are being sent to other places in the world. I would say after-market in balance, and there's clearly some new rigs being built. Not a lot, not as many as were, but some rigs being built.

Thank you. If I can sneak in one more, and I'm sorry for this. But your gross margin performance really was great in the quarter, and obviously revenue has decelerated. How early in the quarter did -- what was the pace of like through the quarter? Did you get ahead of it right away? It was great to management, I'm just curious how fast you anticipate it and how you were able to pull it off?

We're pretty -- we're not perfect, okay? We can always do better, but we are a pretty tight organization. There is -- every month, we have what we call a business performance review. Every one of my staff members is involved, and we go over all the key aspects of the business. We have a sales and operational planning meeting where we go over the input from the OEMs. And we also have the major initiatives are all captured on what we call planning charters, and that's how we set up the budget in the first place, and that is our rheostat in terms of if you see -- frankly, if things are starting to go better, you say okay, maybe we can take on some more initiatives that will add value to the business. But if things are starting to get a little choppy, we're able to dial back fairly quickly. There's not a salaried person who is hired here where a [rep] doesn't cross my desk. We are pretty connected organization on understanding the environment now. There are tougher or easier environments to operate in. That's for sure, but certainly it should not be for lack of awareness and lack of ability to make a conscious decision how we will react to a given circumstance.

Thank you.

Okay, thanks everyone for their time today. We appreciate your interest and support, and we will keep those of you in the path of the hurricane in our thoughts. Have a good evening.

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