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spk02: Good afternoon. Thank you for standing by. Welcome to Allison Transmission's third quarter 2022 earnings conference call. My name is Shamali and I will be your conference call operator today. At this time, all participants are in a listen-only mode. After prepared remarks, Allison Transmission executives will conduct a question and answer session and conference call participants will be given instructions at that time. As a reminder, this conference call is being recorded. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. I would now like to turn the conference call over to Jackie Bowles, Executive Director of Charity and Investor Relations, who has been recently appointed to the role. Please go ahead, Jackie.
spk01: Thank you, Shamali. Good afternoon, and thank you for joining us for our third quarter 2022 earnings conference call. With me this afternoon are Dave Graziosi, our Chairman and Chief Executive Officer, and Fred Boley, our Senior Vice President, Chief Financial Officer, and Treasurer. As a reminder, this conference call, broadcast, and this afternoon's presentation are available on the Investor Relations section of allisontransmission.com. A replay of this call will be available through November 2nd. As noted on slide two 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 2022 earnings press release, our annual report on Form 10-K for the year ended December 31, 2021, and our quarterly report on Form 10-Q for the quarter ended March 31, 2022. Geopolitical uncertainties and related responses by governments, customers, and suppliers, as well as other general economic factors. 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 expressed today. In addition, as noted on slide three 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 2022 earnings press release. Today's call is set to end at 545 p.m. Eastern Time. In order to maximize participation opportunities on the call, we'll take just one question from each analyst. Please turn to slide four of the presentation for the call agenda. During today's call, Dave Graziosi will review highlights from our third quarter 2022 results and provide a brief operational update. Fred Boley will then review our third quarter financial performance and review updates to the 2022 guidance. prior to commencing the Q&A. Now, I'll turn this call over to Dave Graziosi.
spk11: Thank you, Jackie. Good afternoon, and thank you for joining us. We are pleased to report our third quarter results, which reflect ongoing strength in our end markets and the continued focus of our team to drive results, though the operating environment continues to be challenging. The resiliency of customer demand is demonstrated by a 25% year-over-year increase in revenue to $710 million for the third quarter. Notably, year-over-year net sales growth was surpassed by even stronger growth in diluted EPS, up 63%, as Allison's disciplined and well-defined approach to capital allocation continues to support per-share returns in excess of net sales and net income growth. Despite concerns of a slowdown in economic activity, customer demand remains robust, with industry production limited primarily by persistent supply chain constraints. We anticipate that the current complex and uncertain operating environment will continue for the foreseeable future. Though supply chains have not uniformly improved, end user demand remains strong and the Allison team continues to take actions that address and mitigate production challenges. As a result of the ongoing strength in Allison's global on and off highway end markets, we are pleased to raise the full year guidance while narrowing the guidance ranges provided to the market on August 3rd. During the quarter, we announced changes to refresh our board of directors by adding four new members in early August, with four current members serving out their term but not standing for reelection at our 2023 annual meeting. The changes reflect a deliberate process by the board to recruit new directors who will complement the overall mix of skills, knowledge, experience, and perspectives. We are pleased that we have identified four outstanding independent directors who each bring extensive experience in areas relevant to our business and will be great assets to Allison. In prior quarters, we emphasized programs that have gained traction in our driving revenue growth in our conventional business with a combined potential incremental growth opportunity of $250 million in annual revenue, in addition to the 3414 Regional Hall Fractran and China wide-body mining dump initiatives covered in previous quarters. Today, we will highlight new opportunities for our conventional products, as well as provide an update on our electrified propulsion portfolio. As we recently announced, Allison has been named the exclusive provider of transmissions for XCMG's all-terrain crane application. As one of the top three largest construction machinery manufacturers in the world, XCMG has already integrated the Allison 4970 specialty transmission into dozens of its new all-terrain cranes and is seeing outstanding performance, leading to continued growth in the outside North America on-highway market. During the quarter, Isuzu unveiled their new medium-duty FVR truck in Taiwan that features the Allison 3000 series six-speed automatic transmission. The new Isuzu FVR truck was designed to tackle high stop-start duty cycles and numerous application demands, making the Allison 3000 series the proven choice of propulsion to ensure fuel efficiency, enhance maneuverability, and increase the ability to move heavy loads in urban environments. We are pleased to continue our outstanding partnership, and we are confident that the Isuzu and Allison combination will deliver superior economic value to fleets across Taiwan. Additionally, in our outside North America on highway market, we continue to see growth opportunities in the agriculture sector since entering the market in 2015. In South America, leading OEMs, including Cayman, John Deere, and Metal 4, have chosen the Allison 2000 and 3000 series transmissions for their agricultural sprayers. As OEMs have made the transmission, Transitioned from manual transmissions, customers and drivers that operate ag sprayer vehicles have benefited from integrating the Allison fully automatic transmissions due to enhanced performance in soft soil, which is critical in this application. The agribusiness in South America continues to be an exciting growth opportunity for Allison, and we look forward to providing transmissions designed to meet the unique challenges of the industry. In September, Allison participated in the IAA Transportation Conference in Hannover, Germany, where we announced the latest addition to our e-gen power family, the 130S, joining the e-gen power lineup of electric axles, which includes the 100D, introduced in 2020, and the 130D and 100S, both introduced in 2021. The 130S includes new key components designed to specifically support the heavier 13-ton gross axle weight rating often required by commercial vehicles in the Europe and Asia-Pacific markets. The introduction of the 130S is representative of Allison's global approach to electric vehicle propulsion, and we are pleased to expand our e-gen power family of e-axles to deliver additional fully electric solutions for the European and Asia-Pacific markets. Also at the IAA Transportation Conference, we announced the eGen Power 130D e-axle was chosen as the propulsion solution for Quantron's new fuel cell electric vehicle. The Quantron FCEV will utilize the 130D to support sustainability initiatives of customers and drive growth in our electrification portfolio. The implementation of the eGen Power family into fuel cell electric vehicles is a testament to Allison's energy agnostic e-axle portfolio of propulsion solutions which pair well with any source of energy. Furthering our capabilities to support the development of alternative fuel vehicle solutions, we announced this quarter that our vehicle electrification and environmental test center is now capable of both testing and providing hydrogen supply for fuel cell vehicles. We are excited to expand the facility's capabilities to support our OEM customers as they develop and optimize alternative fuel offerings intended to reduce emissions. During the quarter, we announced our strategic cooperation agreement with Anadolu Isuzu, Turkey's leading bus and truck manufacturer. As part of the agreement, Allison's eGen Power 100S will be incorporated into Anadolu Isuzu's light duty truck and midi bus platforms for refuse distribution and public transportation applications. Allison's conventional transmissions have been a preferred solution for their bus platforms for more than a decade, and we are excited to expand our offering and continue our longstanding relationship by delivering innovative solutions to our customers. Early in the quarter, we announced the award of a $6.5 million contract from the U.S. Army's Ground Vehicle Systems Center. This award will be used to support the design, development, and testing of our newest addition to the EGEN portfolio, the EGEN Force. Allison has combined its decades of experience in both combat vehicles and electric hybrid propulsion solutions to develop the new EGEN Force electric hybrid system. Designed for 50-ton tracked vehicles, the EGEN Force meets the requirements for the U.S. Army's optionally manned fighting vehicle program, and has been selected as the propulsion solution for American Rheumatau's Lynx vehicle. The eGen Force is also scalable to 70-tonne tracked vehicles, making it capable of meeting future main battle tank requirements as well. Finally, the eGen Flex, our zero-emission capable electric hybrid system that provides bus fleets with the optionality of full electric engine-off propulsion for up to 50% of the duty cycle, continues to gain share across transit properties in the United States. We recently announced that the Santa Clara Valley Transportation Authority has selected the eGenFlex propulsion system for its fleet of transit buses. This order represents the largest and most recent in a series of nationwide awards for buses equipped with Allison's next-generation electric hybrid system. As we have often said, there are more growth in technology initiatives happening at Allison today than at any other time in our history. We continue to invest across our portfolio to drive growth and deliver value propulsion solutions to all of our end markets. Thank you, and I'll now turn the call over to Fred.
spk12: Thank you, Dave. Following Dave's comments, I'll discuss the Q3 2022 performance summary, key income statement line items, and cash flow. I'll then review updates to full year 2022 guidance. Please turn to slide five of the presentation for the Q3 2022 performance summary. Year-over-year net sales increased 25 percent to $710 million from the same period in 2021, driven by resilient customer demand, price increases, and the continued execution of growth initiatives. The increase in year-over-year results was led by a 24 percent increase in the North American on-highway end market, driven by continued strength in customer demand for last-mile delivery regional haul, and vocational trucks. Year-over-year results were also improved by a 25% increase in the net sales in the service parts, support equipment, and other in-market, principally driven by global service parts and support equipment and aluminum die-cast components, as well as a $26 million increase in net sales in the global off-highway and markets, driven by demand for hydraulic fracturing applications in the energy sector, as well as higher demand in the mining and construction sectors, and a 27 percent increase in net sales and record quarterly revenue in the outside North America on highway and market, driven by the continued execution of growth initiatives in Europe, Asia, and South America. Gross profit for the quarter was $328 million, a 26 percent increase from $261 million for the same period in 2021, The increase was principally driven by increased net sales and price increases on certain products partially offset by higher direct material costs. Net income for the quarter was $139 million compared to $94 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by an unrealized loss on marketable securities and increased product initiatives and commercial activities spending. Adjusted EBITDA for the quarter was $245 million compared to $189 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by increased product initiative and commercial activity spending. Diluted earnings per share increased 63% to $1.45 from the same period in 2021, driven by higher net income and lower total shares outstanding. A detailed overview of our net sales by end market can be found on slide six of the presentation. Please turn to slide seven of the presentation for the Q3 2022 financial performance summary. Selling general and administrative expenses increased $5 million from the same period in 2021, principally driven by higher commercial activity spending. Engineering research and development expenses increased $5 million from the same period in 2021, principally driven by increased product initiatives spending. Please turn to slide eight of the presentation for the Q3 2022 cash flow performance summary. Adjusted free cash flow for the quarter was $182 million compared to $153 million for the same period in 2021. The increase was driven by lower capital expenditures and higher net cash provided by operating activities. Consistent with Allison's disciplined and well-defined approach to capital allocation, we repurchased $109 million of our common stock during the third quarter, representing 3% of outstanding shares. We ended the quarter with a net leverage ratio of 2.5 times, $180 million of cash, and $645 million of available revolving credit facility commitments. In addition, we continue to maintain a flexible, long-dated, and covenant-like debt structure with the earliest maturity due in 2026. Finally, we ended the quarter with approximately $1.1 billion of authorized share repurchase capacity. Please turn to slide nine of the presentation for the 2022 guidance update. As Dave mentioned, given third quarter results and current in-market conditions, we are pleased to raise the full year 2022 guidance while narrowing the guidance ranges released to the market on August 3rd. We expect net sales for 2022 to be in the range of $2.69 to $2.74 billion. Our 2022 net sales guidance reflects higher customer demand in global on-highway, global off-highway, and service parts support equipment and other end markets, as well as price increases on certain products and the continued execution of our growth initiatives. In addition to Allison's 2022 net sales guidance, we anticipate net income in the range of $490 to $510 million, adjusted EBITDA in the range of $915 to $945 million, net cash provided by operating activities in the range of $620 to $650 million, capital expenditures in the range of $160 to $170 million, and adjusted free cash flow in the range of $460 to $480 million. Thank you. This concludes our prepared remarks. Shamali, please open the call for questions.
spk02: Thank you. And at this time, we will be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. And our first question comes from the line of Ian Zafino with Oppenheimer. Please proceed with your question.
spk13: Hi, great. Thank you very much. Glad to see a lot of strength still continuing. You know, can we just like key in on pricing? You know, can you maybe talk about the magnitude of some of your pricing you saw in the quarter and maybe what areas and, you know, what's the outlook for, you know, fourth quarter and beyond from a pricing standpoint? Thanks.
spk12: Hi, Ann. This is Fred. For the quarter on a year-over-year basis, pricing was favorable $29 million. As we look at full year at this point, we previously talked about 400 basis points of pricing. We have taken some pricing within the year and are now anticipating about 425 basis points of price. so roughly $115 million in price on a year-over-year basis. As we talked about on previously earnings calls, as OEMs continue to raise the price of vehicles, and our transmission makes those vehicles more productive, more efficient from a fuel standpoint, they're able to get more work done, it just increases the value of our transmissions. So we certainly feel well-positioned to... continue to capture price in this inflationary environment. Okay. Thank you very much.
spk02: Our next question comes from the line of Tim Thain with Citi. Please proceed with your question.
spk05: Great. Thank you and welcome aboard to Jackie. Maybe, Dave, just on the global on-highway the strength you saw there, which, uh, presumably there, there's some amount of, of currency headwind that, that would even, um, you know, flatter it even more when adjusting for that. But what, what, what do you attribute that? I, I, you know, it's not contract. Lindsay would have gotten this quarter, obviously, but, uh, how much of that is, is strength in maybe China? Uh, well, China, I think on highways is actually worse in the, in the quarter for the industry. So, I don't know, what areas of the country, or not of the country, of the world would you highlight in terms of driving that strength, or continued strength, rather? And what kind of, I mean, visibility is always a challenge in the on-highway space, but what do you have as you're looking forward to that specific market in 23? How do you kind of size that up? Thank you.
spk11: You're welcome, Tim. So let me just... go around the world here quickly. So, North America, as I'm sure you've read some of the public reporters that are out already with their comments, I don't believe we would disagree with the general market conditions that are being described for North America, which is relatively strong. You know all the attributes that are supporting the market right now in terms of significant backlogs. because of a lack of production really dating back to 2020 into 21 at this stage, it certainly supports a relatively, from our perspective, expectation for a pretty healthy market over the near to medium term. It's relatively broad for us, although, as you know, with our portfolio, we do have a fair bit of business in the vocational space that continues to to be strong for us, and that's prior to some of this infrastructure legislation that's been passed to actually take hold. But I would say overall, North America continues to be a pretty strong market. Outside of North America, I think our team has done a very solid job supporting customers in a number of different markets at this stage, as you know. We've talked about the asymmetric reopenings that have occurred, also some interim stops along the way in Asia that I'm sure you're familiar with. I think we've been extremely supportive, as I've said, to try to keep both the end users certainly up and running, but also the OEMs to the extent that they have product and enough components to make vehicles, but I would say broadly there isn't really a market out there that I would describe outside of North America that's weak. I think all of them are relatively strong. You know, we'll get to the 2023 guide, as you know, we always do with the fourth quarter call in the first quarter. So, I won't, you know, jump ahead of that at this stage, but I would say, you know, more broadly, our expectation is, again, subject to continued market conditions in terms of supply chain which does have, you know, some challenges more broadly without a broader macro displacement at this stage that, you know, we do expect a decent tailwind heading into 23. So beyond that, as I referred to in the prepared remarks, you know, supporting the growth initiatives that we have, I think the team continues to do a very good job executing against those, and we're pleased with that outcome. Specific to China, as you mentioned, that market continues to be, for us, a combination of truck domestically in a number of areas, including mining, but on the export bus side as well. They've had a pretty decent year so far. So beyond that, I think, again, we'll keep a close eye on things as we head into the end of the year. but the market's relatively strong overall.
spk03: Got it. Thank you, Dave.
spk02: Our next question comes from the line of Jamie Cook with Credit Suisse.
spk03: Please proceed with your question.
spk08: Sorry. Hi. Good afternoon, or I guess good evening. I guess just two questions. One, the strength in the parts and service business struck me this quarter, you know, up 25%. So can you just, and the drivers behind that, how much was market versus sort of, you know, pricing and how sustainable is that level? Just given it's probably a creative to your margins. And then, you know, my second question, Dave, is to you, just, you know, with the strength of the balance sheet and the cash flow and, you know, valuations coming in across the market. If you could just update us on what you're seeing in terms of, you know, M&A opportunities, and is there opportunities, you know, for Allison to be more acquisitive relative to history? Thank you.
spk12: Jamie, this is Fred. Relatively to the strength on the, you know, the service parts, support equipment, and other components, It was primarily driven by the service parts. But we also had, obviously, a strong unit volume. So the support equipment used to support the initial installation was up. And we were also up with aluminum die-cast components. So it was pretty broad-based. It was definitely a strong quarter. You continue to see, obviously, trucks running longer, more repairs needed, obviously some challenges within the channel from a labor standpoint to get all that done, but definitely a strong quarter, candidly a little stronger than we had anticipated when we forecasted things.
spk11: Jamie, it's Dave. So on your balance sheet or CAF allocation question, I guess directly or indirectly, relative to M&A opportunities, you know, we continue to stay very close to the market and a number of our contacts. I think our business, as you know, you've followed us for a number of years, continues to become broader in terms of number of activities that were involved and beyond. You know, Allison's more than a transmission company. We are thinking of ourselves and the market more broadly in that context. So I would certainly point to we believe there's a number of opportunities for the team here to add value for our shareholders. Having said that, you know, we are a patient bunch and very disciplined. You know, we do expect there will be opportunities at the same time at appropriate valuations, as you would expect of us. I also think more broadly about, you know, as we at this point in the cycle with the market where it is, you know, the market is more broadly busy in terms of our core markets. So that being said, I do think there, you know, there will be a number of opportunities, whether those are near term or not. remains to be seen just given the broader market conditions. What I mean by that is, you know, as best I can tell, you know, everybody's relatively busy. So given that as a backdrop, plus I think some of the challenges more broadly in the financial markets, as you're well familiar with, you know, it's something we continue to be very focused on, but very patient and disciplined about how we're thinking about opportunities.
spk08: Okay. Thanks so much. Nice quarter.
spk02: Our next question comes from the line of Rob Redheimer with Mellius Research. Please proceed with your question.
spk06: Hi. Good evening, everyone. I wanted to ask about two things, I guess, on the advanced powertrain side. One is I don't know if you have an update on eGenFlex and just the hybrid transmission and whether that's kind of a I don't know whether that's a growing market or a legacy market where fleets have adopted it, you know, continue to replace and expand with it or if it's real growth. And then just more generally, I'd love it if you could just give us an update. You've been very active across Advanced Powertrain on the state of the market, whether customers are, you know, buying for efficiency, where you see your market positioning, where you see your win rates and the things that you want to win, just the general state of development. Thank you.
spk11: Thank you for the questions, Rob. It's Dave. So just on the eGen Flex, understand the legacy of that product dates back about 20 years. It was very unique at that point. I think there's over 9,000 of those systems running globally at this point. The EGEN Flex was really the next generation of that what we used to refer to or what is known in the market as the H4050. The big difference with the EGEN Flex is that we added full EV capability up to 10 miles and a number of attributes around 50% in EV mode on a duty cycle up to et cetera. I would say certainly a much more advanced product and solution. I also think it's very responsive to the customer around zero emission zones. So the long of all that is, as you think about that, it's really a successor product with a number of improvements that are responsive to the marketplace. So it's more of the future, if you will, but really dealing with mark in position, if you want to think about it that way. In terms of your question on the broader advanced powertrain space and a number of opportunities that we're looking at, you know, we continue to receive a fairly high level of interest in our e-gen power lineup of e-axles. You know, I was mentioned in the prepared remarks, i.e., Hanover I think our team showed very well at the show itself. We had a tremendous amount of traffic in and out of our booth there, a number of, I think, very good quality meetings, a lot of attention paid to our products, especially our solutions when they're compared to a number of other parties in the marketplace. So, you know, I also mentioned the prepared remarks, the Quantron effort. We're being relatively focused and selective about who we're choosing to work with at this point. The gist of all that is that it's really focused on being power agnostic, but thinking about our focused efforts around the Allison brand promise and solutions that, frankly, are consistent with our products, which, as you know, have a reputation for being extremely effective high-quality and reliable, and we believe anything we're going to field in terms of alternative power trains, advanced power trains, are going to meet or exceed the conventional standard that we've created. So that's really the focus of any engagements we're having at this point. So I think we're very pleased with the team's reception in the marketplace and the progress we're making. And, you know, again, I think we continue to also leverage the investments that have been made over the last few years through acquisitions, talent that we've brought on since then, but also the facilities we've now added, whether that be our team in Auburn Hills and also the vehicle electrification and environmental test center here in Indianapolis, which are very, it's a very unique facility, but it's also given us the ability to partner with in an accelerated way with a number of parties. So, you know, I think the overall summary is pleased with where we are. We see a lot of opportunity there. But I would also note, you know, it's still relatively early days for some of those powertrain solutions in general. And, you know, we're prepared to be patient and do things the right way, consistent with our brand promise.
spk03: Thank you.
spk02: Our next question comes from the line of Felix Boshin with Raymond James. Please proceed with your question.
spk03: Hey, good afternoon, everybody. Afternoon.
spk04: Hey, you know, I'm curious about some of the opportunities from a revenue perspective. You've called out the regional hall, the dump body initiative in China, and the Fractran. I think it's about a $250 million revenue opportunity all in. I'm just kind of curious if you can maybe give us an update on those three launches, what may or may not already be in the numbers versus what's sort of slated to come online in coming years would be super helpful.
spk12: Sure, Felix. This is Fred. As you can imagine, they're all three at different stages. The regional hall, has been out there for a couple years. We've achieved releases with Navistar, Daimler, Volvo. Certainly what's notable there is a couple of VI, OEMs. The wide-body mining dump in China, we've seen some fairly fast adoption there. And then you go to the Fractran, which is really still early stages from a launch standpoint. So So the $100 million opportunity from Fractran, there's really no revenue within the run rates. The wide-body mining dump, it'll be interesting to see how we finish the year. We targeted that at $50 million. There's been really quick adoption. I think we'll probably be halfway there. And we may have undershot what potential opportunities there is, so we continue to look at that. Regional haul is... You know, we've got, you know, a lot of the key releases. We've got customers that have tried, you know, five, ten units, which is pretty normal, you know, in the conventional market, especially in North America, conservative end users that are coming back for, you know, their second, third purchase. You know, but as far as where do we stand versus that, you know, that $100 million, you know, probably 10% there, you know. So a lot of this is still in front of us, and then, you know, it's As Dave talked about in the prepared remarks, you know, there's a lot of activity that's ongoing. You know, I mean, you know, record outside North America on highway, you know, defense business. We've made, you know, a significant amount of investments there. You know, and some of those programs are coming to fruition with the M88, the MPF. You know, obviously, you know, the conflict in Ukraine driving, you know, you know, the Western European OEMs to, you know, to rebuild their fleets that a lot of that stuff's been, you know, put into theater there in Ukraine. And just in general, anybody, you know, historically that's been using Russian equipment is, in a lot of cases, looking for, you know, other sources. So, you know, quite a bit of opportunities were, you know, very Pleased with the pace we're on with those three, but we're not done. There's a significant amount of opportunity to continue to drive this conventional business forward.
spk04: Helpful. I appreciate it.
spk02: Our next question comes from the line of Tammy Zakaria with JPMorgan. Please proceed with your question.
spk07: Hi. Thank you so much for taking my questions. So my first question is, how should we think about your gross margin rate in the fourth quarter? Because it seems like gross margin rate erosion has finally inflected and you had leverage in the third quarter after several quarters. So any thoughts on how you're thinking about gross margin in the fourth quarter and then also next year, maybe given some of the commodity prices are coming down?
spk12: Hi, Tammy. This is Fred. Really, as we look at the fourth quarter, and I'm sure you've probably done the math on the implied guide into the fourth quarter. Traditionally, fourth quarter is the softest quarter just because of the fewer number of production days with the holidays. As we look at it, that is how we anticipate it this year. We do you know, we've started to see, you know, some commodity prices, uh, you know, roll off. So, um, certainly expect to be, you know, uh, price costs favorable in the, uh, in the fourth quarter. Um, you know, as, as relative to 2023, you know, we're, we're doing a significant amount of work around 2023. You know, we definitely anticipate getting price, uh, but, uh, you know, continue to model the top line and the cost structure. And we'll provide commentary on that when we put out, you know, Q4 results in February with that initial 2023 guide.
spk07: Got it. Thank you. That's helpful. If I can squeeze in one quick one. How should we think about the defense business? When do you expect that to start growing again year over year?
spk11: Tami, it's Dave. So to Fred's comments, a number of programs that we're working on, new programs and some both through the U.S. government as well as outside North America. The answer to your question is in the next really year or two, you should start to see defense increase I would say once you get out within, you know, two years, call it, subject to the programs actually being funded and occurring on time, which is I'm specifically referring to tracked programs, you know, it's a pretty meaningful ramp versus history. You know, back 10-plus years ago with the activities in the Middle East, it was largely, you know, if you looked at our defense business, largely wield in terms of volume. The team has spent the last four to five years working very aggressively on growing both our U.S. presence as well as outside North America. To Fred's point, the unfortunate situation with the Ukraine has created, frankly, a new market space for Allison. So the team is also engaged on in that process as well, but we're certainly looking forward to significant growth from our defense portfolio at this stage.
spk07: Got it. Thank you so much, and great quarter. Congrats on that.
spk11: Thank you.
spk02: Our next question comes from the line of Jerry Ravage with Goldman Sachs. Please proceed with your question.
spk10: Yes, hi. Good afternoon and good evening. I'm wondering if you could just talk about the fourth quarter sales outlook at the midpoint of the range. I think you'd be down mid-single digit sequentially, which is worse than seasonality we've seen over a number of years. So I'm wondering, is that just a function of allowing the supply chain room to execute, or are there any end markets specifically where you're expecting lower deliveries? And You know, similar question on margins. So the midpoint implies margins are down 200 basis points sequentially. And I'm wondering if you talk about are there discrete items driving that or is that, again, just to provide room to execute given the supply environment?
spk12: Thanks. Hi, Jerry. This is Fred. Yeah, I think, you know, one thing, you know, important to look at is certainly, you know, we did, you know, increase guide, both from a revenue earnings and cash. But specifically, as we look at Q4, we have revenue much closer to Q2. Q3, for us, $710 million, one of our strongest revenue quarters in history. You know, we do have Q4 down, which is, I would say, is normal seasonality, although, you know, last year was really unusual with Q4 being our strongest revenue quarter. You know, specifically when you get, you know, you're looking at the various end markets, you know, I wouldn't say anything necessarily stands out, you know, but Parts of the port equipment and other was really strong in Q3, and we don't anticipate repeating at that level. We do expect North America off-highway to be down quarter over quarter. And then really back to your question on margins, it's primarily just a function of the reduced revenue and associated drop-throughs. impact in Q4, and as I mentioned, it's very common for Q4 to be the lowest margin quarter for us of the year.
spk10: And sorry, Fred, just a clarification. What part of the parts that support equipment? Is it the off-highway piece, the die-cast piece? Just a little more context on where you're anticipating that.
spk12: I think we have a lot of strength in global on- and off-highway So it was really an outlier quarter, Jerry. So that's the portion that we're not anticipating recurring in Q4.
spk10: Super. Nice quarter. Thanks. Thanks.
spk02: And our next question comes from the line of Sharif El-Sabahi with Bank of America. Please proceed with your question.
spk09: Hey, good evening. I just wanted to discuss gross margins a bit more broadly. Could you walk us through some of the changes over the past few years that have impacted gross margin and sort of break them out by what's more cyclical or structural? And then within those moving pieces, what do you see coming back that could drive margin to return to more historical levels?
spk12: Sherif, this is Fred again. It really depends on how far you go back. You know, the biggest challenge with margins have been the significant cost increases, which primarily began with raw material. And what we've, you know, we talked about on previous calls, if you would see raw material returning to sort of pre-pandemic levels, that should provide about a 200 to 225 basis point lift to, you know, our gross margins. And we do have, you know, on those commodities, we have pass-through methodologies within a lot of our long-term supply agreements, but we don't pass through 100%. And then, you know, we don't have the entire book of business on long-term supply agreements. So, you know, as raw materials have increased, we've only passed through about 60% via our surcharge methodology. And that's traditionally lagged 6 to 12 months. So, you know, you are starting to see commodities roll. You know, in the short term, we don't have to pass those on. And then ultimately when we do, it'll be 60 cents on a dollar. That's been, you know, that's been the biggest impact. You know, the second thing would just be just general operational inefficiencies. That's occurring with, you know, the challenges in the supply chain. You know, the challenges of our customers to build what they want to build. It creates, you know, inefficiencies for both our suppliers and for our manufacturing facilities. So I think as you move through and get more strength within that supply chain, those are costs that I think we all look forward to removing.
spk09: Understood. Thank you.
spk02: And we have reached the end of the question and answer session. I'll now turn the call back over to David Graziosi for closing remarks.
spk11: Thank you, Shamali. And thank all of the call participants for your continued interest in Allison and for participating on today's call. Enjoy your evening.
spk02: This concludes today's remarks. You may disconnect your line at this time. Thank you for your participation.
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