Allison Transmission Holdings Inc (ALSN) 2018 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Allison Transmission Third Quarter 2018 Results Conference Call. My name is Melissa, and I will be your conference operator today. (Operator Instructions) As a reminder, this conference is being recorded. (Operator Instructions) I would now like to turn the conference over to Mr. Ray Posadas, the company's Director of Investor Relations. Please go ahead, sir.

Thank you, operator. Good morning, and thank you for joining us for our Third Quarter 2018 Results Conference Call. With me this morning are Dave Graziosi, our President and Chief Executive Officer; and Fred Bohley, our Vice President, Chief Financial Officer and Treasurer. As a reminder, this conference call, webcast and the presentation we are using this morning are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through November 6.

As noted on Page 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These forward-looking statements are subject to known and unknown risks, including those set forth in our third quarter 2018 results press release and our annual report on Form 10-K for the year ended December 31, 2017, and 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.

In addition, as noted on Page 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. 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 2018 results press release. Today's call is set to end at 8:45 a.m. Eastern Time. (Operator Instructions)

Please turn to Slide 4 of the presentation for the call agenda.

During today's call, Dave Graziosi will provide you with an overview of our third quarter results, including net sales by end market. Fred Bohley will then review the third quarter financial performance and the 2018 guidance update.

Finally, Dave will wrap up the prepared comments prior to commencing the Q&A. Now I'll turn the call over to Dave Graziosi.

Thank you, Ray. Good morning, and thank you for joining us. We are pleased to report that third quarter 2018 net sales growth exceeded our expectations and the guidance ranges provided to the market on July 30, and 2018 is on track to be a record year. Third quarter year-over-year net sales growth of 16% was surpassed once again by even stronger growth in net income, up 50%, diluted EPS, up 69% and adjusted EBITDA up 22%.

Additionally, our established and well-defined approach to capital structure and allocation remained intact. During the quarter, Allison settled $86 million of share repurchases and paid a dividend of $0.15 per share.

Please turn to Slide 5 of the presentation for the Q3 2018 performance summary. As I just mentioned, net sales increased 16% from the same period in 2017, principally driven by higher demand in the Global On-Highway, Outside North America Off-Highway and Service Parts, Support Equipment & Other end markets as well as price increases on certain products and the continued execution of our growth initiatives.

Gross margin for the quarter was 53.2%, an increase of 240 basis points as compared with 50.8% for the same period in 2017, principally driven by increased net sales, price increases on certain products and favorable material cost. Favorable material costs were principally driven by several multiyear cost reduction initiatives, partially offset by unfavorable raw material cost.

Please turn to Slide 6 of the presentation for the Q3 2018 sales performance summary. North America On-Highway end market net sales were up 10% from the same period in 2017, principally driven by higher demand for Rugged Duty Series models. North America Off-Highway end market sales were down $5 million from the same period in 2017, principally driven by lower demand from hydraulic fracturing applications. Defense end market sales were up 20% from the same period in 2017, principally driven by higher Tracked and Wheeled demand.

Outside North America On-Highway end market net sales were up 8% from the same period in 2017, principally driven by higher demand in Asia. Outside North America Off-Highway end market sales were up $32 million from the same period in 2017, principally driven by improved demand in the energy, mining and construction sectors. Service Parts, Support Equipment & Other end market net sales were up 18% from the same period in 2017, principally driven by higher demand for North America service parts and global support equipment. Now I'll turn the call over to Fred.

Thank you, Dave. Please turn to Slide 7 of the presentation for the Q3 2018 financial performance summary. Given Dave's comments, I'll focus on other income, statement line items and adjusted EBITDA.

Selling, general and administrative expenses increased $11 million from the same period in 2017, principally driven by higher warranty expense commensurate with increased net sales, favorable dual power inverter module extended coverage and product warranty adjustments in 2017 that did not recur in 2018 as well as increased commercial initiatives spending.

Engineering research and development expenses increased $7 million from the same period in 2017, principally driven by increased product initiative spending. Interest expense net increased $4 million from the same period in 2017, principally driven by higher interest expense associated with the 4.75% senior notes due October 2027 that were issued in September 2017.

Other income net increased $4 million from the same period in 2017, principally driven by credit related to postretirement benefit plan amendments. Income tax expense for the third quarter of 2018 was $51 million, resulting in an effective tax rate of 23%, versus $59 million of income tax expense and an effective tax rate of 35% for the same period in 2017. The decrease in effective tax rate was principally driven by the U.S. Tax Cuts and Jobs Act enacted into law in December 2017.

Net income for the third quarter of 2018 was $167 million compared to $111 million for the same period in 2017. The increase was principally driven by increased gross profit and lower income tax expense, partially offset by increased selling, general and administrative expenses and increased product initiatives spending.

Adjusted EBITDA for the third quarter of 2018 was $295 million, or 42.6% of net sales compared to $241 million, or 40.5% of net sales for the same period in 2017. The increase in adjusted EBITDA was principally driven by increased net sales, price increases on certain products and favorable material cost, partially offset by increased selling, general and administrative expenses, increased product initiatives spending and increased manufacturing expense commensurate with increased net sales.

Please turn to Slide 8 of the presentation for the Q3 2018 cash flow performance summary. Net cash provided by operating activities increased $24 million from the same period in 2017, principally driven by increased gross profit and decreased cash interest expense partially offset by higher operating working capital requirements, increased product initiatives spending, increased cash income taxes and increased commercial activities spending. Adjusted free cash flow increased $21 million from the same period in 2017, due to increased net cash provided by operating activities partially offset by increased capital expenditures.

As Dave mentioned earlier, during the third quarter we continued to execute our established and well-defined approach to capital structure and allocation by settling $87 million of share repurchases and paying a dividend of $0.15 per share. Finally, we ended the quarter with a net leverage of 2.16, $221 million of cash, $533 million of available revolving credit facility commitments and $598 million of authorized share repurchase capacity.

Please turn to Slide 9 of the presentation for the 2018 guidance update. As a result of the outperformance during the third quarter, and taking into consideration current end market conditions, we are updating our full year 2018 guidance as follows: net sales are expected to increase between 18% to 19% over 2017, versus our prior expectation of a 15% to 18% increase; net income is expected to be in the range of $600 million to $620 million, up from our prior expectations of $570 million to $600 million; adjusted EBITDA is expected to be in the range of $1.09 billion to $1.11 billion, versus our prior expectation of $1.04 billion to $1.08 billion; net cash provided by operating activities is expected to be in the range of $785 million to $805 million, up from our prior expectations of $765 million to $795 million; capital expenditures are expected to be in the range of $90 million to $100 million, a modest increase from our prior expectation of $85 million to $95 million; adjusted free cash flow is expected to be in the range of $685 million to $715 million, versus our prior expectation of $670 million to $710 million; and cash income taxes are expected to be in the range of $100 million to $110 million, up from our prior expectation of $90 million to $100 million.

Allison's full year 2018 net sales guidance reflects increased demand in Global On-Highway and Global Off-Highway products, price increases on certain products and the continued execution of our growth initiatives.

Although, we are not providing specific fourth quarter 2018 guidance, Allison does expect fourth quarter net sales to be up from the same period in 2017 and down sequentially.

Now I'll turn the call back over to Dave.

Thanks, Fred, and as most of you are aware, this is a meaningful time of change in our industry and an exciting time to be at Allison Transmission. We are leveraging our 103-year history of innovation to continue the heritage of leadership in the markets we serve and to introduce valued products and solutions to our customers. Let me give you a few examples. Last year, we announced our first 9-speed, fully automatic transmission, currently undergoing testing in demonstration vehicles and targeted for production release in 2020. More recently, at the IAA Commercial Vehicles show, we announced the global launch of the medium-duty, fully automatic 9-speed transmission.

With its steep first-gear ratio, industry-leading ratio coverage and integral engine stop-start system, the Allison 9-speed transmission provides significant fuel savings. And, when combined with the FuelSense, our proprietary software and electronic controls packages, as well as Allison's other fuel-saving technologies, the 9-speed will set a new benchmark in fuel efficiency and reduced emissions around the globe.

Also during IAA, Allison announced the expansion of its electrification portfolio with an electric hybrid system that includes a purely electric extended range up to 15 kilometers, ideal for transit bus and motor coach applications. The system features 0 emissions with engine off, including approaching, during and departing passenger stops, for a quieter and healthier environment. This hybrid with extended electric range builds on one of the most dependable and efficient hybrid propulsion systems in the world. With over 8,000 buses using our systems since 2003, Allison has been, and continues to be, a pioneer in electrification and a trusted brand.

Beyond the 9-speed transmission and the extended electrification portfolio, Allison continues to work with telematics service providers and vehicle manufacturers to support existing and new customers with connected capabilities for a single efficient fleet management experience. The latest connected capabilities will provide insight into over 170 different transmission conditions and provide fleet managers and maintenance staff with the awareness they need to improve vehicle uptime. We expect to begin delivering transmission health information via multiple North American TSPs by year-end, with support for additional applications in global regions planned.

Last week, we announced our long-awaited return to the Class 4-5 medium-duty market, with the upcoming release of Chevrolet's highly anticipated Silverado 4500HD, 5500HD and 6500HD trucks. Following a nearly decade-long absence, GM will be reentering the medium-duty market, exclusively with the Allison 6-speed automatic paired with the Duramax diesel engine, a legendary combination that has powered almost 2 million trucks.

And finally, last Thursday, we announced an expanded partnership with Leonardo DRS to develop onboard vehicle power systems for military vehicles. This latest collaboration involves a fully integrated generator within the housing of an Allison 4500 Specialty Series transmission installed into the driveline in its original configuration without affecting vehicle functionality. The latest OBVP system is intended for a heavier class of military vehicles, such as the 44-ton Oshkosh Heavy Expanded Mobility Tactical Truck, equipped with anti-ballistic missile launchers. It will also improve agility and reduce logistics costs, as the vehicle will no longer have to be equipped with an external or a trailer generator.

When matched with the Leonardo DRS power electronics, the system will have the capability to produce up to 120 kilowatts of electrical power for use on or off board the vehicle. OBVP systems have potential uses off the battlefield as well, state and local emergency response agencies could use such systems during natural disasters to power emergency shelters, for example.

When daisy-chained, such systems could power hospitals, senior citizens homes, water purification plants and other vital infrastructure. Our commitment to innovation and the optimization of commercial vehicle propulsion drives us to engage with multiple OEM partners to further accelerate the evolution of the commercial vehicle industry. Over the coming quarters, we will continue to update the market on Allison's latest technology innovations and developments. That concludes the prepared remarks. Please open the call for questions.

(Operator Instructions) Our first question comes from the line of Tim Thein with Citigroup.

My question just is on product mix, and so I'm just curious if you can help us as to how we should think about the impact that, that product mix is pulling, just from a margin perspective in '18, given the growth in some of the heavier-weight North America On-Highway segments and service parts, just -- as we make our own assumptions about how these may play out in '19 -- just so we can kind of level set as to what kind of impact it may be having here in '18, again, just from an overall product mix perspective, and how the interplay with margins plays out?

Sure, Tim. This is Fred. From a mix standpoint, really, looking year-over-year for the quarter, relatively neutral. Obviously, you had a step down in North America Off-Highway, which was expected and we had talked about on the Q2 call, but that was more than offset by the pickup in Off-Highway Outside North America,

and as we've ranked the end markets, both of those fit in our second tier, so that was relatively neutral. Another strong parts quarter, our highest ranked end market; but up 18% versus the overall net sales up 16%. Global On-Highway continues to be strong. Defense coming in at 20%, so slightly higher than average, with the Tracked portion driving a lot of that performance, which is one of our lower end-market products, based on the cost plus fixed-fee nature. So relatively speaking, Tim, we considered kind of a neutral mix for the quarter. The question probably then is: where does the margin performance come from? And we -- thinking about, (inaudible) significant amount of operating leverage in the business. We had a very strong price quarter. We also -- with commercial performance, with our suppliers, we're able to more than offset the raw material increases. So we were favorable, from a material cost, a couple of million dollars. And then from the manufacturing cost standpoint, continued to drive operation efficiencies. So the vast majority of that margin performance driven by operating leverage, price and then performance within the supply chain and our operations in-house.

Our next question comes from the line of Larry de Maria with William Blair.

I just first want to start -- the -- obviously, the topline performance has been exceptionally strong this year generally, almost across the board. But when we think about moving into next year and recognize that you don't have guidance yet, can you just maybe talk from a high level about -- maybe you want to frame it as where we are, in what inning in the cycle for each end market, or just how we can think about framing the puts and takes into next year from a high-level?

Sure. Larry, this is Dave. So a few things there. First is, as you know, I think our practice is we'll address next year. So when we report the fourth quarter results, we'll be commenting on our expectations for 2019. With that in mind, I -- we can certainly provide a bit of a weather report by end market. North America On-Highway, obviously, our largest -- as we talked about on the second quarter call, one thing that was really -- or the -- I think the major constraint in North America On-Highway volume was more supply-chain-driven than demand. I would certainly say -- and I'm sure you're well aware of public commentary from OEMs and other parties, third-party forecasters, et cetera, but given that the third quarter results and expectations that have been discussed for fourth quarter, those constraints are, I think, largely still in place. So that, by definition, provides some level of tailwind going into 2019, I guess has been the argument from everybody. As we think about '19, we're certainly positioning ourselves to be able to continue to supply customers in a timely way, assuming receipt of timely and accurate forecast. Also, working on investments in our supply chain to ensure a consistent supply. Having said all that, I think 2019 really comes down to more, at this point, of a first-half, second-half debate. Again, tailwinds are certainly helpful, but as you think about the run rates, and as we've talked about, we don't view necessarily current market as an absolute peak. We would say it's the first year in at least the last cycle here, extended cycle back to 2019, that we have a level of production above the 10-year average, so as you think about what that means, it really does get back to underlying growth in terms of demand. The fact is North America, as the third quarter even developed, we continued to see a fair bit of demand in last-mile vehicles and such. I'm not aware of any underlying changes to the market that really drive that in a different direction, and we're also continuing to see strength in construction and vocational markets. So I think that covers off North America On-Highway. As we think about North America Off-Highway, as we talked about on the second quarter call, issues with the Permian Basin continued in the second half as we expected. There is certainly commentary out there from others that those constraints will be removed. Does that provide some level of better positioning for 2019? Obviously, we believe it does, but that's another area that has certainly had its challenges in terms of some supply chain constraints. So that's an area we've focused on as well. Outside North America On-Highway, again, by region, I would certainly say the emerging markets, as everybody knows, has proven to be more volatile as the year has progressed. A number of reasons for that, that most are familiar with. Do we expect that to necessarily change in 2019? At this point, I would say no. We're also still trying to understand, as well as everybody else is, the potential impact of the various actions around tariff sanctions, et cetera, so that's something that needs to be thought about and included in our planning. But I don't believe any of those geopolitical issues at this point we would expect to change dramatically. If you look at the more developed markets and mature markets, as we think about Europe is reasonably stable, we believe, at this point. So that's a market that we continue to focus on, more so truck than bus. Outside of that, as I said, with China, bus is challenging, given the continued push for electrification there, but we've seen a tremendous amount of hard work by the team and coming out of Japan for the Australia market that's grown significantly this year. The backdrop to that is infrastructure spending, amongst other areas. We would expect that to be a relatively stable outcome in 2019.

Beyond that, I think it's still very early days in terms of developments for the situation in Brazil given their recent elections as well as where India goes for 2019. Outside North America Off-Highway, again, very strong performance here in the third quarter. We would expect that to continue, given other public commentary around mining and construction and other related industries. Certainly, the expectation there is a reasonably solid market in terms of demand. The energy side has been stronger in the second half for China as well. I think it's early days to be commenting on that in terms of 2019 at this point. Parts, Support Equipment & Other, as a broader market, you're familiar with. The Off-Highway demand this year for North America in terms of supporting that market, as we said, we expected that to soften a bit in the second half, and unfortunately, we were correct. As we think about 2019, again, that gets back to positioning for the Permian Basin and some other areas. As we think about Defense, strong performance this year, and I think it's very early to be commenting on Defense, just given, frankly, budget decisions that need to be made that we don't control, as well as the outcome of the midterm elections next week.

Our next question comes from the line of Joe O'Dea with Vertical Research Partners.

Just a question on cash and how much cash you really want to have on the balance sheet. If we're looking at this year with $700 million of free cash flow and a little bit under $200 million that would go to the dividend and CapEx, trying to think around, moving forward, what do you do with another $500 million of cash generation there? Are you thinking about building that on the balance sheet at all? Are you comfortable continuing to deploy that to buybacks?

From a capital allocation standpoint, as we mentioned in the prepared remarks, it's consistent. For us, it starts with a net leverage target over the cycle. We're going to fund the business with -- when the opportunities provide appropriate returns. We've got the dividend in place, $0.15 per share. The balance of the cash will be returned to shareholders, and that's consistent with past practices. I think if you looked at last year, we bought back about 15% of our shares, I think we've bought back about 8%, year-to-date. So there's -- from a cash standpoint, we ended the quarter with about $200 million in cash. Higher than we need, but certainly not within the range of where we've held from a historical standpoint and just the optionalities that, that cash provides.

Our next question comes from the line of Ross Gilardi with Bank of America Merrill Lynch.

You called out a 5% sequential decline in European On-Highway in the text of the press release. Is the market actually slowing, or is that seasonal?

I think the -- in terms of the reference there, there is always, obviously, some seasonality to the markets. I would say this year, in terms of Europe specifically, it's really been growth around truck, to a degree. Bus is typically challenged from a tender perspective, right, in terms of timing. So I would not necessarily draw any conclusion specifically for the quarter itself, other than I think the broader tonality, as I mentioned earlier, the market continues to be reasonably stable there. And there's also, underlying in that market as well, some level of defense spending that continues to take place. But, reasonably pleased with how the market's evolved this year and certainly positioning for 2019, and our team there has done a nice job supporting the OEMs as they're, frankly, launching a number of different new programs and platforms.

And then you gave a nice rundown of just preliminary thoughts on demand into next year and current conditions. At this point, is there anything you would call out from a margin perspective that we should think about into -- in the next year?

It's a -- appreciate you asking that question. I'm sure Fred would love to jump on this one. I'll give you my, at least thoughts are as we think about '19. You've -- I mentioned earlier, in terms of some of the tariff issues, that's still evolving. That's clearly going to create a bit of a headwind for us. Do I consider that to be significantly material to our results? No. But as I start thinking about puts and takes, we would certainly expect some price next year, as we usually do. We have a number of cost pressures that I think are going to carry into next year. Beyond, I think, the uncertainty around the tariffs, there is commodity pressure there in terms of aluminum and the 3 grades of steel that we focus on as well. You're certainly familiar with a number of the challenges that all businesses apparently are facing right now, which is some level of pressure on wages. The benefits side, we continue to work very hard on as the team and our broader colleagues here, in terms of what we're trying to do to contain those costs, but I would say overall, that's more or less cost expectations. To Fred's earlier comment on operating leverage, assuming relatively similar volume outcomes, specifically in the On-Highways business globally, or in that range, we should be able to generate, I think, pretty attractive -- continue to generate pretty attractive incrementals.

Beyond that, I would also mention that, as we started the year and we talked about late last year, we're continuing to invest in our business in all end markets. I don't expect that to change going into 2019. The team is working very hard in all of the end markets to identify opportunities and work more closely with OEMs at all levels of their organizations as well as end users. That's requiring us to invest in not only personnel to do that and support that, but also on the innovation and research and development side.

We've talked about our commitment to delivering valued propulsion solutions across the entire range, from conventional through full electric. That continues to be a focus for our team, and I think it's worth certainly highlighting once again, that is all end markets. So I would not look at any particular end market and say the increased level of activity that we have is focused on one particular propulsion solution. It's not; it's across the entire range and across all of our end markets. So again, I would expect that to carry into 2019 as well.

Got it. That's helpful. And then just on North America Off-Highway, when you compare that to what you've seen in Parts and Support, it seems a little bit unusual that, that market has rollover so much faster than the Parts and Support business, although the Parts and Support's obviously got a lot of On-Highway in it. So what I'm asking is, have you seen the slowdown in the Permian also impact that parts business, or is it just that the North America On-Highway was unusually strong and is masking, maybe, some deterioration there?

We -- I would say for third quarter, as we talked about, we expect -- certainly expected a moderation in the second half. Clearly on the units side, I would argue or at least make the point that the parts space aftermarket for Off-Highway actually performed a bit better overall than we were expecting. Having said that, the positioning, clearly, to your point specifically around the Permian, is -- I've read most of the public reporting that we have access to over the last week, and there's clearly, I think, a focus there on positioning for a strong start to 2019. That may explain some of what we've seen in terms of activity. But at some level you'd also have to assume you reach critical mass in terms of how those fleets are being managed and positioned. I think it's always a point of focus for us as well, which is -- last time we checked -- there is usually only one sale at the end of the day on the other side of things, so how many different fleets are counting on the same activity. You'd probably argue the same thing in terms of On-Highway OEMs, but the point is, there is some level of critical mass that's going to be reached. And that's the things that we're paying attention to right now and trying to understand much better. And again, all of that is reliant on those constraints in the Basin being removed, and there is lots of variables to that.

Can you just help us a little bit on the year-to-date mix of Parts and Support, just On-Highway versus Off-Highway? And just any granularity in the difference in growth rates, On-Highway versus Off-Highway, in the third quarter?

Yes. I would say, just taking On-Highway, there really wasn't -- if you look at it, again, third quarter year-over-year specifically, On-Highway really didn't have that much of a change. The broader focus there was really around the North America Off-Highway, as I mentioned, as well as support equipment, just because of the volume of units that we're selling. So that really covers off the third quarter. As you think about overall mix for the year in terms of expectations, clearly, as we started the year, and it's turned out to be true, fortunately, that the North America Off-Highway parts business is certainly up year-over-year is our expectation for the full 12 months. I would say On-Highway in general has moved up slightly when you look at the balance of the changes overall. I would certainly say, beyond the obvious, which is support equipment tied to volume in largely the On-Highway space, that really explains the overall change in levels or allocations for Parts, Support Equipment & Other year-over-year.

(Operator Instructions) Our next question comes from the line of Ian Zaffino with Oppenheim & Company.

A lot of my questions have been answered, but David, can you just touch on the Class 4 comments you made. Maybe give us an idea of what you think the market size for you is as far as the market shares or maybe the margin opportunity, and how to think about that?

When you -- when -- just to be clear, we talked referring to the business with GM, specifically (inaudible) Class 4.

And then any opportunity to expand it? Yes.

Sure, the -- as you know, and to my comments, the -- GM exited that business back in 2009. So prior to their -- GM exiting that business, we enjoyed a meaningful portion of share in that, call it, 4-5 space. So, as we've talked about in other periods, this is something that's been on our list of things to do, certainly. I think it's safe to say we are targeting back to a 10%-plus type of position there in terms of market share in that space. So we -- that would imply, on a run-rate basis, north of $30 million a year in incremental revenue as you think about that. So we'll work through that. I would avoid at this point, or demur on margin comments specifically, other than to say it's -- we would expect that business to be relatively consistent with other 4-5 ASPs that we have for the -- that series of product. So again, we're very supportive of GM's launch and look forward to returning to that space and doing what we can to drive the growth with them in a market that's been largely, you would argue, unchallenged for the better part of 10 years.

Our next question comes from the line of Rob Wertheimer with Melius research.

Could you just talk a little bit about where you're seeing strength, Outside North America Off-Highway? And then just briefly if there's any progress on wins or platforms in China?

Sure. This is Dave. The -- couple of things. So with Outside North America, as you know, typically Off-Highway more of a balanced portfolio than North America Off-Highway, which is largely weighted towards energy. History would say it's roughly a 50-50 split, energy versus construction and mining, outside North America. This year, we've certainly seen healthy growth in China, specifically around energy. Europe price, certainly more growth there around -- or an increase in mining and construction I think as we've mentioned before. Several new releases there, with Volvo construction equipment and Bell as well. So I think there -- those vehicles are performing well, they are well supported in terms of the marketplace. I would say China is something -- it's not lost on us, in terms of the size of that market relative to mining, construction and hauling, and something that our team is focused on and very engaged with relevant OEMs in that space. That is something we would expect to have quite a bit of focus around opportunities there going into 2019 as well. Energy, the one thing I would mention there Outside North America, as it's proven to be -- as most energy markets are -- somewhat volatile, so we certainly think about post-2018, that's always a topic to keep in mind, is how that moves around, as we have seen fits and starts there before. It does not -- this particular time in that process does not feel like it was a few years ago when they had a significant ramp-up in terms of equipment and then went dark, per se. This feels like we're into a more mature market. But we shall see, in terms of sustainability broadly, there. And I think to your point on releases, I mentioned the VCE and Bell; the team is also working with multiple OEMs on other releases.

Our next question comes the line of David Leiker with Robert W. Baird.

This is Joe Vruwink for David. How intertwined is North America Off-Highway and international Off-Highway in the sense that, does the weakness in the Basin may be free up capacity, and allows you to go after opportunities that maybe you wouldn't have prioritized on an international front? And doing that in Q3, obviously, I think this was an all-time record quarter for the international Off-Highway business, so does that uncover more opportunities? Or do you really view kind of each business in isolation with their own targets?

We capacitize, both internally and with our supply chain, to be able to grow in the global markets. So to your point, in terms of the -- some of the lack of demand in North America creating opportunities, I would certainly describe us as positioned to take advantage of those opportunities, regardless of what's happening in North America. So it's the team's job here, and they've done a great job of that over the years, which is positioning the business to be able to supply demand when it's there. I don't think this particular point is any different, other than that the speed of which the market has accelerated has certainly challenged a number of the -- points in the supply chain that we've discussed earlier this year. And as I mentioned on the -- earlier in the call, it's something that the team is working to address as well. But we feel good about where that is, and I would also tell you our growth initiatives, as we've talked about over several quarters now, each one of the end markets has a set of growth initiatives that we drive towards, so I would not describe us as particularly constrained, from a supply perspective, to pursue any of those at this stage.

Our next question comes from the line of Jamie Cook with Crédit Suisse.

Just 2 quick follow-up questions. David, you provided a lot of good color on how you're thinking about '19, but, just specifically, can you talk about how you feel about the quality of the order book out there? There is concerns on cancellations, we're hearing OEs are putting in cancellation fees, and you're generally more upfront, so if you could speak to that? And then Fred, anything to read into -- when I think about the EBITDA guidance for the year, it implies the fourth quarter is, I don't know, like 37.5%, 38% relative to the run rate in the first 9 months of the year, which have been more like 42%?

Jamie, I'll -- it's Dave, I'll take that first part. As we look at the order boards here, to your question there, a lot of comments over the last week or two. I would say it's interesting to us as we, again, have talked to OEMs and end-users as well. There seems to be a real focus now on trying to push so-called excess out of that order board. I think there are a number of OEMs that have talked about some of the initiatives that they've had around doing that. I think you mentioned in terms of cancellation fees. Really, as we've heard from a number of dealers, OEMs forcing them to either confirm off on an order or they lose a slot type of thing. So I think that's a healthy point for the industry to take, from a positioning standpoint. The fact is, everybody is apparently challenged by supply chain constraints. Right now, I would say for -- our team has done a solid job performing to schedules that have -- we've been provided with -- that are accurate and timely, largely, to deliver. We're not perfect, but I would say that we're certainly, I believe, outperforming the broader market right now. I think with the order boards more broadly, again, there is some variation -- inventories is the other side, frankly, that we're spending some time thinking about. That's a little bit -- another challenge, as you think about optimal levels, they appear to be elevated slightly versus expectations or at least a healthy range. I think that, combined with some of these activities around order boards and -- so offsetting that, you would have to argue, there is some level of tailwind as well, which is the inability to deliver right now. So if there is deferrals, I think that provides some push into '19. But to my earlier comments, I think then we're really focused on a first-half, second-half debate.

And as it relates to Q4 EBITDA margins. I think if you look, Jamie, historically, you would see that Q4 is traditionally one of our softer quarters, really driven by the number of work days at the OEM and the top line revenue. As we're looking at Q4, we have SG&A expense elevated from Q3, closer to the Q1, Q2 run rate. And we also have engineering, research and development up from the Q2 and Q3 run rate, really driven to the timing of some of our product initiatives spending. So a lower top line and some additional expense from an SG&A and R&D standpoint is what's considered in our guidance.

Our next question comes from the line of Jerry Revich with Goldman Sachs.

Fred, your guidance for top line. I think it bets roughly at 10% sequential decline in sales and production, 4Q versus 3Q. Can you just flesh that out in terms of the biggest drivers? I'm assuming Parts is the biggest one. But can you just talk about what's driving that bigger-than-normal sequential decline in this fourth quarter?

Yes. As you think about it, we've got the On-Highway business down in North America, driven by the -- as I said, the number of work days and the OEM production build. We've got the Defense business slightly down from the Q2, Q3 run rate. Outside North America, again, there's a day rate thing there, down -- On-Highway down slightly, as well as the Outside North America Off-Highway, very robust Q3. We do have that modeled down in Q4. And then you mentioned Parts, Support Equipment & Other and -- consistent with our comment on the Q2 earnings, we do expect Off-Highway -- North America Off-Highway parts to continue to moderate. So those are the primary drivers of the Q4 revenue guide.

And Fred, can you just say more about the non-North America Off-Highway outlook, 4Q versus 3Q. You folks had a record quarter in 3Q, I guess, how much of that was driven by the initial ramp-up on the new platforms that you mentioned, versus what's the run rate? Can you flesh that aspect of the guidance out for us?

Sure. I mean, we have it down from Q3, Jerry, but we do have it up from Q2. So it's still going to be a strong quarter as we have it in the guidance.

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

My questions have been asked and answered.

Our next question comes from the line of Ann Duignan with JP Morgan.

Most of my questions have been answered too. But I will ask about the run rate for R&D and SG&A. The SG&A, I think you mentioned increased commercial activity spending. I mean, is that -- should we read that as buying market share? And then increased product initiatives spending and R&D. What's the right run rate for both of those to think about for 2019?

It's Dave. 2 quick things there. So SG&A, we're certainly driving, as I mentioned earlier on the call, supporting the end markets activities in terms of staffing, amongst other activities, from an engineering perspective. So we don't, I would say respectfully, buy market share, frankly. So we sell the product based on the value that it delivers. So I think that position continues for our team. But I think the efforts around spending more time with the OEMs and end-users, both at a commercial and technical level, is certainly generating some incremental costs for our team. And I -- as I said earlier, would expect that to continue into 2019 on the engineering R&D side. As we started this year, the expectation was we were going to -- had a number of opportunities, most importantly, to invest in; we are in fact doing that. Those opportunities have not changed; if anything, I would point out that there's more than we started the year with. I think it's a nice challenge and problem for the team here to have, to have plenty of things to work on and add more value to our products and solutions for our end users. So I would expect, again, that process to continue into 2019. Specific to that, there are a number of programs that are in flight, we're also refining our planning. So we look forward to providing, I think, a more fulsome answer to your question when we provide fourth quarter results and full year 2019 guidance in the first quarter next year.

Our next question comes from the line of Rob Wertheimer with Melius Research.

I'm sorry, my follow-up was answered.

Thank you, ladies and gentlemen, we have come to the end of our time allowed for questions. I'll turn the floor back over to Mr. Graziosi for any final comments.

Thank you, Melissa. Thank you again for your interest in Allison and for participating in today's call. As the results of the quarter demonstrate, Allison continues to make excellent strides forward, introducing innovative solutions while remaining intently focused on driving shareholder returns. Enjoy the rest of your today.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.