Westinghouse Air Brake Technologies Corporation

Good morning and welcome to the Web Tech second quarter 2020 earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note, this event is being recorded. I would now like to turn the conference over to Christine Kubacki, Vice President of Investor Relations. Please go ahead.

Thank you, Operator. Good morning, everyone, and welcome to Wabtec's second quarter 2020 earnings call. With us today are President and CEO Rafael Santana, CFO Pat Dugan, President of Freight Services Pascal Schweitzer, Senior VP of Finance John Mastelers. Today's slide presentation, along with our earnings release and financial disclosures, were posted on our website earlier today and can be accessed on our Investor Relations tab on WAPTECCorp.com. Some statements we're making are forward-looking and based on our best view of the world and our business today. For more detailed risks, uncertainties, and assumptions relating to our forward-looking statements, please see the disclosures in our earnings release and presentations. We will also discuss non-GAAP financial metrics and encourage you to read our disclosures and reconciliation tables carefully as you consider these metrics. And now I will turn over the call to Rafael.

Thanks, Christine, and good morning, everyone. We appreciate you joining us today, and I hope you and your families remain healthy and safe. Before we get started, I'd like to once again thank our employees out in the field, in our factories, and those working from remote locations for continuing to keep our facilities safe and operational through this pandemic. I'm very proud of how our teams has responded to the challenging environment, delivered for our customers, and supported one another during a time when healthcare, economic, and social tensions run high. And you see that reflected in our second quarter results in long-term focus. Turning to slide three, we had a strong execution in the second quarter despite a difficult environment. Total sales for the quarter were $1.7 billion, driven largely by the international freight market and services, but offset by disruptions due to COVID in both the freight and transit end markets. Adjusted operating income was $262 million, resulting in an adjusted margin of 15.1%, which was impacted by the drop in sales across freight and transit, but somewhat offset by synergies. Cash flow from operations of $311 million was driven by strong cash conversion and good working capital performance. This allowed us to further strengthen our financial position, pay down debt during the quarter by $300 million, and increase our liquidity position by $700 million. Total multi-year backlog was over $21 billion, providing us continued visibility across freight and transit despite market conditions. And finally, we ended the quarter with adjusted EPS of 87 cents, demonstrating that we're taking the steps necessary to control what we can, protect the long-term viability of the company, and deliver shareholder value. With that, let's dive into some actions underway. As you know, we remain committed to our synergy targets, and we're accelerating our efforts here. We have $150 million of net synergies planned for 2020. Year-to-date, we are on plan with over $70 million in net synergies realized, and we remain confident that we will deliver on the full run rate of $250 million in synergies ahead of schedule. Of particular note, we continued the aggressive action on structural costs and lowered the SG&A expense by 26% year-over-year. During second quarter, we reduced headcount by 5%, and we're down more than 10% year-over-year. We have also reduced our operational footprint year-over-year, and we're actively driving cost reductions through lean initiatives. To date, we have exited more than 60% of the shared service agreements from GE Transportation merger ahead of schedule. Looking ahead, the rail transportation market and impacts from the pandemic remain challenged and fluid. While we anticipate market conditions to remain somewhat mixed, as I'll share with you in a moment, We believe volumes largely bottomed in the second quarter, and we will see a gradual recovery. With this in mind, and based on our first half results, as well as based on the backlog coverage for the rest of the year, we are issuing a new outlook for the 2020 year. Pending no further lockdowns due to COVID-19 pandemic or resulting negative impacts on our business, we expect revenues in a range of $7.3 billion to $7.6 billion for the year. We will continue to adjust our variable and fixed costs to align with volume realities, and we are committed to improving segment margins. We anticipate adjusted EPS to be in the range of 350 to 380 and cash conversions to be greater than 90% for the full year. This includes roughly $130 million from prior restructuring and transactions cash outflows. Cash conversion within the company's core business is expected to be over 100%. Turning to slide four, I'd like to discuss the market conditions and drivers we are seeing across the sector. Pascal Schweitzer, President of Freight Services, will also hit on some of this in a few minutes. In both freight and transit, we are experiencing mixed conditions as economic recovery begins and commuter travel resumes. And we're carefully monitoring the ongoing impact of the virus in some regions. In North America, rail volumes had a record decline, down roughly 20% year-over-year in the second quarter. However, we have seen rail volume improve since bottoming in the second quarter. Likewise, locomotive parkings, after peaking to a record high in the second quarter, have also shown gradual improvements, and we remain positive on the aftermarket sector. In terms of the North American rail car builds, A record one-third of the North America rail car fleet is in storage, and builders are taking continued steps to slow down production lines in 2020. Industry forecasts currently indicate that the rail car build for the year will be less than 30,000 cars. Reflecting on the quarter, I want to share a couple highlights. Internationally, rail volumes were more resilient, driven largely by agriculture and mining tailwinds. International locomotive shipments were off versus last year and helped offset North American locomotive and freight car build declines, as expected. We continue to see demand for new locomotives in Russia, CIS, Brazil, and Australia. Some tenders have pushed to the right due to COVID-19, but we expect this to resolve as economies stabilize. New growth opportunities for next-gen sustainable solutions also remain strong, especially for hybrids and fuel-saving technology. We are doing some really innovative work in reducing fuel consumptions by 5% through our engine overhaul process. Pascal will share more on this in a moment. We're also currently fuel testing our flex-drive locomotive, the first 100% heavy-haul battery-powered locomotive in the world operating in a hybrid consist. So far, we are seeing an opportunity to reduce fuel consumption for our customers by 10% to 30%. We are extending battery technology to passenger transit as well and just closed a significant deal with New York City Transit to drive down their overall carbon footprint. Finally, we continue to see our digital electronics product line provide significant productivity and improve safety for our customers. Sales for the quarter were up 4% versus the prior year. Transitioning to the transit sector, the COVID-19 crisis has had a significant impact on ridership and service levels in early second quarter. Since then, particularly in Europe and Asia, ridership trends are showing as low recovery as economies reopened. This has resulted in some positive activity internationally with new brake, new doors, and HVAC contracts in regions like Australia, Canada, India, and the UK. Overall, we believe the long-term market drivers for passenger transport remain intact, especially as governments look to rail as the cleanest, safest, and the most efficient mode to address the world's public transportation challenges. Across the segment, we also continue to drive costs down. We continue to improve project execution and profitability. Lillian and the team are on track to expand margins over time while delivering over 100 base points of improvement in 2020. With that, let's flip to slide five and I'll turn things over to Pascal.

Thanks, Rafed. Good morning, everyone. It is good to be with all of you today. I am Pascal Schweitzer, and I am the Group President of WAPTEC Trade Services. This is a roughly $2.2 billion business with operations in around 40 countries and approximately $12 billion in backlog. Roughly 80% of our revenues are generated through multi-year contracts, including long-term service agreements, part contracts, as well as multi-year modernization agreements. So in short, we are with our customers for the long haul, helping them pull freight in some of the most important logistics corridors around the world. As I've shared before, we are executing on a focused strategy to create value for our customers. This includes ensuring that our fleet is performing well and running hard, that we are capturing the aftermarket with a superior product and delivering outcomes for our customers through technology upgrades and new tools. All this while constantly improving our fleet's total life cycle costs. Today, as railroads continue to hunt for productivity and efficiency gains through initiatives like precision schedule railroading, for instance, and in the midst of challenges brought on by the pandemic, this strategy is more relevant than ever. The second quarter, as Raphael explained, we saw significant disruption in many of the regions where we operate. Government shutdowns had an impact on our customer operations and freight volumes globally. As a result, a record number of locomotives were parked in North America. However, despite this, we continue to have a leading and increasing share of the total active fleet, and our customers continue to increasingly prioritize the dispatch of our locomotives, due in large part to the performance and reliability of the fleet. I would also like to point out that in the second quarter, we did hit record performance for on-time parts delivery. And despite regional disruptions and shutdowns from COVID, each of our more than 100 service locations remained open and fully operational. It's a huge testament to the team in the field, and this is a strong illustration that we do so much more than sell parts. You see that's reflected in the resiliency of our second quarter top line. So while the uncertainty related to the crisis has led some railroads to delay certain investment decisions, the value of our portfolio remains. We have worked with our customers to align scheduled maintenance plans to the new market realities, and as a result, we have leveraged the full power of WAPTEC to increase the scope of our work and to unlock new growth scenarios. Now looking ahead. As railroads enter into recovery and the growing level of freight relying on a smaller number of locomotives, we expect the demand for reliability to be even greater. This will translate into more comprehensive work scopes, into more comprehensive fleet strategies, into modernization opportunities. Currently, we have more than 1,000 modernized locomotives in operation, delivering improved reliability, better fuel efficiency, and overall economic performance for our customers. As our customers strategically consider their investment plans over the long term, the value of modernizations remains very compelling. The second quarter, mod deliveries showed good momentum, and we continue to have visibility via our multi-year backlog. Now, on a broader international scale, where economies have started to reopen, we are also seeing encouraging improvement in parking and operational fleet performance. Just to give you a few examples, In Australia, rail activity has shown good momentum throughout the quarter as China resumed business following the COVID lockdown. In Kazakhstan, year-to-date, car volumes are up compared with 2019. In Brazil, we see a strong demand with greater dependency on agricultural products following a record harvest. In India, while there were a significant number of locomotives parked due to the pandemic, This ultimately had little impact to our business as we shifted focus to maintenance, and as of July, all of these locomotives are back in operation. Finally, in North America, as discussed, we do expect carload volumes to continue to gradually improve and parking to progressively recover. In terms of commercial activity for the quarter, the team closed some significant long-term service agreements with Class 1s in North America, as well as in Brazil, and won a key order for our FDL Advantage product. Going into this product a little bit more specifically, as Raphael described, we have around 10,000 FDL locomotives running globally. Many of these locomotives are approaching their second or third engine overalls. So with these next-gen solutions, we are able to reduce the fuel consumption by up to 5%. That means for a single locomotive burning around 200,000 gallons of fuel a year, around $25,000 in savings per year. This is an exciting first win that is opening up a multi-million dollar pipeline of opportunity for WAPTEC, fully in line with our strategy of technology differentiation for the install base. Finally, I share a few thoughts on cost management. The last year, we have reduced our headcount by roughly 10% ahead of our synergy commitments and in line with market realities. We have undertaken lean initiatives to drive costs out of the business while still being able to deliver for our customers and scale up as market recovers. To conclude, while the market remained fluid and carload volumes and parking drew significant headwinds, the freight service system had a strong operational quarter, giving us confidence that our broad international portfolio, our $12 billion multi-year backlog, and our strong aftermarket reach will position us well into the future. Looking forward, you will see some fluctuations quarter to quarter due to the seasonality of maintenance activity, due to our engine overall profiles and mod delivery schedules. However, the fundamentals of this business and its ability to recover post-COVID remain strong. I will now turn things over to Pat to provide more color on the company's overall second quarter performance. Pat? Thanks, Pascal.

Turning to slide six, sales for the second quarter were $1.7 billion, which reflects a 22% decrease versus the prior year. The decline in year-over-year sales was mainly due to disruption across our freight and transit segments caused by the COVID-19 pandemic. In the first quarter, operating income was $159 million, and adjusted operating income was $262 million. That's down 32% year-over-year. mainly driven by the lower sales and the disruption in our operations as a result of the pandemic, offset somewhat by variable cost actions and the realization of our synergies. For the quarter, adjusted operating income excluded pre-tax expense of $103 million, of which $72 million was for non-cash amortization, $31 million of restructuring and transaction costs. Take a look at the Appendix D to our press release for the reconciliation of these details. Looking at some of the detailed line items, SG&A declined 26% year-over-year to $217 million, including $13 million of the restructuring and transaction expenses. SG&A expense benefited from structural cost actions across the business, as well as the realization of synergies. Engineering expense decreased to $38 million, or down 33% from last year. Engineering expense moved down with the lower volume outlook, as well as some changes in project timing. And amortization expenses were $72 million. In 2020, we expect non-cash amortization expense to be about $290 million, and depreciation expense of about $180 million. In the second quarter, and adjusted earnings per diluted $0.07. Details that bridge the gap earnings per share to adjusted earnings per share of $0.87 can be found attached to our press release. As of June 30th, our multi-year backlog was $21.4 billion, diluting the impact of FX. The backlog is flat quarter over quarter. A rolling 12-month backlog, which is a subset of the multi-year backlog... 5.3 billion. The backlog continues to give us and provide good visibility across both the freight and transit segments. Now let's take a look at those segments, the results on slide seven. Across the freight segment, total sales decreased 21% to 1.2 billion in the second quarter. FX negatively impacted sales by about 26 million during the quarter. In terms of product lines, equipment sales were down 37% year-over-year as a result of lower North America locomotive deliveries, which, as we have discussed, often can vary quarter-to-quarter due to timing. That was offset somewhat in the second quarter by higher year-over-year international locomotive deliveries and increased mining sales. In the second half of the year, we expect locomotive deliveries to be slightly higher when compared to the first half of this year. And as you heard Pascal discuss, our services portfolio continues to show resiliency despite the OE headwinds. Despite a nearly 18% drop in North America freight volumes for the quarter, services revenues were down 8% year over year. a result of lower part sales due to record locomotive parkings, but that was offset by double-digit growth in mods deliveries. We expect our part sales to improve with the gradual recovery in freight volumes and see some timing of maintenance and overhaul work edging into the fourth quarter. Digital electronic sales were up 4% year-over-year on higher sales of distributed power products and signaling projects. Crone and sales were down 30% year-over-year on lower year-over-year rail card build and lines in key industrial end markets such as oil and gas and power generation. Despite the top-line headwinds, evidence of our synergies coming through as segment-adjusted operating income was $229 million for an adjusted margin of 19%. Finally, the freight segment would note again that FX negatively impacted that backlog by about $58 million. Turning to slide eight, across our transit segment, sales decreased 25% year-over-year to $533 million, driven largely by disruption stemming from the COVID-19 virus, but were also impacted by FX, which reduced sales by an additional $18 million. OE sales were down 32% year-over-year on disruptions caused by the pandemic. During the quarter, our operations and our customers' operations, which are primarily in Europe and Asia, were negatively impacted by government shutdowns. Aftermarket sales, which were down 18% from last year, were impacted by reduced capacity at many transit systems around the globe. However, as economies have opened up, we have seen a resumption in service Increased equipment deployed, gradual recovery, and ridership in most markets. Our adjusted segment operating income was $51 million for an adjusted operating margin of 9.6%. Margin performance was impacted by the lower absorption of fixed costs in the first half of the quarter. However, we are continuing to drive improvements in the transit business and expect transit margins to increase 100 basis points for the year. Finally, the segment backlog was 3.4 billion, also about flat with last quarter. FX negatively impacted the backlog by 79 million versus the end of the first quarter. Let's turn to the balance sheet and the cash flow on slide nine. Cash flow generation during the quarter was strong at 311 million. I would note that we had about 40 million of one-time impacts due to prior year restructuring and transaction charges we had identified on our last earnings call. Our leverage ratio at the end of the second quarter was 2.7 times, about flat with the last quarter. But our total liquidity at the end of the second quarter was $1.9 billion, up solidly from the $1.2 billion at the end of the first quarter, and total net debt is down about $282 million. Also in July, we took proactive steps to restore a more balanced maturity profile of our debt with a successful five-year, $500 million bond offering that retired $500 million in floating rate notes due in September of 2021. In summary, our balance sheet is strong, and we are confident in our ability to generate cash flow, giving us the liquidity and flexibility to execute our strategic plan. With that, let's move to slide 10, and I'll turn the call back over to Raphael. Hey, thanks, Pat.

So as you heard throughout the morning and you see on this page, Wattac had a solid performance in the second quarter despite a weak and fluid environment. A reminder that in difficult times, strong companies must learn how to adapt, find a better way, and lead through change. We could not have imagined a greater stress test for our company and how it would perform in a difficult environment than the one we're seeing here today. Over the last 17 months, we have successfully managed a massive merger that doubled the size of this company. We faced into the global pandemic and an industrial recession in one of the most difficult business cycles ever seen. Yet, despite all the odds, We are performing strong and we have delivered a true testament to the team and their commitment to position this company as a stronger and more resilient WAPTEC. Heading into the second half of the year, we fully expect to see continued headwinds. Our leadership team remain confident and committed to manage cost and to drive profitable growth that will help us navigate these challenges. I want to personally thank each and every member of the WAPTEC team again for all that they are doing in the face of change. Your efforts are reflected in the results we shared today. With that, I'll turn the call back to Christine to begin the Q&A portion of the discussion.

Thank you, Rafael. We will now move on to questions. Before we do, out of consideration for others on the call, I ask you that you limit yourself to one question and one follow-up question. If you have additional questions, just please rejoin the queue. With that, operator, I think we're ready to take our first question.

Thank you. To ask a question, you may press star and 1 on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. And our first question will come from Justin Long with Stevens. Please go ahead.

Thanks. Good morning, and congrats on the quarter. Good morning, Justin. So maybe to start with the 2020 guidance. So if I look at the revenue guidance, it implies of the year, revenue should get better relative to the second quarter. As we think about just the mixed implications, can you give us some color on how much of that sequential improvement in revenue you anticipate to come from freight versus transit, and then anything just on a quarterly basis that you can provide to help us think about the cadence of revenue or earnings in the back half?

Sure. Justin, let me start first with, well, as we look at the backlog coverage for the ranges we've provided, we feel strong about that. I think we also feel strong about the strength in the execution. We've got, I'll say, a strong momentum in terms of both synergies and cost actions that we're taking. I think in the second quarter, we certainly saw volumes bottoming for our customers. We think there was also, when we think from operational disruptions, I think we also, to some extent, have seen the worst. I don't think we're through that. I think we have seen improvement in the trans storage at the end of the quarter. I point out to that with un-parkings of locomotives, ridership levels on the transit side. have improved a bit, but I think the better news there, you've got a large number of trains still operating. So I think we're continuing to see those trends. There is, of course, some volatility as we see and as we look into the recovery, but we're seeing trends up starting at the end of the second quarter, and we're continuing to see that through this month of July as well. I don't know if you want to add any more specifics into it.

No, I think the one thing I would point out is that, you know, when you kind of look at our information as it becomes available, the mix of aftermarket versus OE, the decline is much more significant in the OE side, kind of quarter over quarter, year over year. you see that it's really being impacted by the disruption in the industry and the market. And so I think to get to your question of where and how those recoveries, I think the recovery is going to be in both segments, and I think you're going to see it coming back to a more typical mix of businesses as the year goes along.

I think one of the things we'll be watching for is really any push-outs on decisions with regards to new projects, and I think that's something for us to continue to monitor here as we continue to build backlog.

Okay, great. And then maybe, Pat, on the cadence part of that question for third and fourth quarter, do you feel like third quarter is maybe a little bit worse and then we kind of build off of that into the end of the year? Any color on that front?

Yeah, you know, I just want to be careful about guidance to quarters and everything, but I think you see sort of a kind of a steady sequential improvement as we go through the rest of the year.

Okay, helpful. And as my second question, I wanted to ask about free cash flow. I know you made the comment about the cash conversion percentage this year, but any more specific thoughts around free cash flow in 2020 and how that cash could be allocated between debt pay down and maybe potentially even buybacks? I don't know if that's something you're considering at this point.

Well, a couple points. I think we've given clear guidance to cash conversion being above 90%. I think we remain committed to that, and I think we have the areas of opportunities here to act. If you look into areas like inventory, for instance, we'll continue to have a strong rigor around that, and we feel strong about delivering above 90% cash conversion here.

Yeah, and as for the allocation, I think it's obviously one of the most challenging times, and we want to make sure that we focus on debt repayment and then get into other uses of capital. I don't think – I think it's too early to really be talking about anything – you know, aggressive, but we want to remain opportunistic. And that's the way we've approached this. We're generating cash. We're meeting our goals. And then we're using it to get our debt in the right kind of ratio range, as we've always talked about. and be opportunistic for all the other things that we can do.

We remain committed to the framework we presented during the investor day, and there is a commitment to continue to pay debt down, but we're going to be looking at opportunities here, and especially we can see bolt-on acquisitions being, I'll call, more available than they were maybe six months ago. And we'll make sure to evaluate that against the different options. So we're committed to that framework we've presented back at the Ambassador Day. Okay, great. I really appreciate the time.

Thanks. The next question comes from Chris Weatherby with Citi. Please go ahead. Hey, thanks, Citi. Good morning.

I was curious if you could provide a little bit more sort of color on the outlook for the second half on freight segments. So looking through sort of equipment and components and kind of giving a sense of how we should be thinking about that revenue rebound relative to what we see in the freight market. Services and digital obviously held up fairly well, but when you think about those two pieces, do those kind of move linearly with recovery in volume, or how are you guys expecting that to play out in the second half?

I think... I'll probably point out three tanks to be really watching. Of course, the impact for both customers and operation was very significant in the second quarter. As we go into the second half, I think first, really watching closely on the freight side, the unparking of locomotives. Whether it was North America or international, I mean, we have seen the impact in the second quarter, and as those unparking occurs, I think we have seen that trend. It's not linear, but I think there's some brighter spots than one places versus others. Especially internationally, I'd say we see some of those brighter spots. We see them across some geographies and driven by, well, either agriculture or specific mining. There's still some markets where they're heavily underpenetrated. So I think we see... good dynamics coming from some of these markets. And it's reflected also in the pipeline of what I call opportunities for equipment deals. So what if I talk about agriculture in Brazil or mining in Australia? We're also continuing to deliver on our contract in India. You take a country like Kazakhstan's volumes, car loads are actually up. year over year, year to date, and that's also, I think, a significant opportunity for us.

Okay, okay, that's very helpful. I appreciate that color. And then just a detailed question about the 12-month backlog. I just want to make sure I understand sort of what the progression has been over the last couple of quarters. So that's come down a bit, and I know FX is probably some of it. I'm just kind of curious. Have we seen any of the sort of 12-month outlook get pushed out into the right? I think there are some comments about that maybe in the prepared remarks. I just want to make sure I'm understanding sort of what the 12-month view is, because obviously the long-term is very stable. I just want to make sure how we're seeing that kind of play out over the course of the sort of more immediate term.

I'd say certainly when I look at second quarter, even first quarter, I mean, I can't say those were necessarily great in terms of all favoring a dynamic of ordering tech. I think when you compare first quarter against second quarter, and if you were to exclude FX, you will see a backlog remains flattish quarter over quarter. I think as we look at it ahead, I mean, we're... We're really in the business of looking for business. We're chasing every piece of opportunity that we can go after. Our strategy here is to grow the business profitably, and I'd say we're continuing to act to have a more competitive cost structure than ever before. I think, yes, we are seeing some of the decisions moving to the right, and I think, especially if you think about some of the dynamics in the transit side with Really, despite of the fact that ridership is low, I think we're seeing a number of trains in operation. So operators are really reevaluating some of these. But we think the long-term fundamentals, whether if I look at transit or freight, remain strong. And we are seeing a commitment to actually be investing in these modes. And this is part of the solution. As we look at the world ahead in terms of well-driving, more efficient, more productive, less emissions, and I think we sit in a good place in terms of the long-term fundamentals for the business.

Okay. That's helpful. I appreciate the call. Thanks very much.

Our next question comes from Allison Poliniak with Wells Fargo. Please go ahead.

Hi, guys. Good morning. Good morning. I just want to delve into Chris's question a little bit more on the freight aftermarket piece, particularly as it relates to North America. I guess just given the focus from the rails in terms of increasing utilization versus bringing equipment back, I would have thought your freight aftermarket, I think you said it wouldn't recover one-to-one, but I would think it would actually recover a little faster as a result of that. Any thoughts there, or am I thinking about that wrong?

Well, a couple comments there. Number one, I mean, we felt the impact in the second quarter in North America. I mean, it was brutal, right? I mean, as you look into the numbers, you've heard – from the class ones, and we've seen volume reduction pretty close to those numbers that you've heard. If you think of transactional parts, and I think some of the class ones alluded to like 20% down, yeah, I mean, we did feel that directly. I think what we've also seen is from the bottoming of the volume, which fundamentally happened the first two months of the quarter, we've seen that improvement come through. That's also being true not just for North America. We've also seen that in the international markets. And we do expect recovery to happen there faster, especially as fleets are unparked. It's all dependent on the pace in which those fleets get unparked. I think we're seeing a faster rate of recovery on international markets. I think I mentioned here earlier some of the dynamics on agribusiness mining across some of the geographies that we serve. And we're certainly seeing, I'd say, a much faster recovery. In fact, some customers actually up year over year in terms of car loads in some of these geographies.

Got it, got it. And then I just want to turn to transit in terms of the recovery in terms of U.S. versus global. I know global is a much bigger impact for you on transit. Any differences that you're seeing in those markets in terms of how they're recovering or interest investing in infrastructure going forward?

I think the recovery in terms of, number one, ridership has been a little bit better in Europe if you were to compare against the U.S., but reality is it remains well below what I'll call the pre-COVID levels. I think the better side of it is we've seen, I think, a number of trains in service and operations are very significant despite of the ridership being down. So I think we can also be looking at service levels despite maybe a lower decline going into a faster recovery. And I think the other element is I think as far as project scales, we haven't seen any, again, cancellations or anything with regards to the impact of this year. There could be an element of things pushing to the right in terms of just project delays when customers might want equipment. I think that's one of the elements that we're going to keep monitoring.

Great. Thanks so much. I'll pass it along.

Our next question comes from Courtney Yacovonis with Morgan Stanley. Please go ahead.

Hi, great, thanks for the question, guys. You've talked a little bit about, you know, kind of the bottoming in volumes and ridership in transit, and I appreciate kind of a lot of questions on kind of the aftermarket, but could you kind of clarify, you know, what the exit rate trends that you're seeing, kind of that improvement off of, you know, the down 18% in transit aftermarket, you know, and then similarly in the freight services side, kind of how you've seen that recovery progress so far? kind of as you've gone through the quarter and the exit trends?

So I think in terms of the exit trends, I mean, again, we saw it going back up some of the demand in both terms of orders but in terms of sales versus the first two months of the quarter. I think in specific, I'd say in transit, I think beyond that, I think we've taken significant actions in the business area Lillian, the team, is really committed to continue to take the necessary cost actions. And I look at a year to date. We're 110 base points margin improvement versus the first half of last year. I think we've talked to you about being at least 100 base points improvement year over year. So despite of what I'll call a really unprecedented quarter in many ways, we're very much on track. to deliver on that promise. So still a lot of work to do. Still subject to a lot of disruptions, but we feel like the team is heading the right direction here.

Okay, and then just on the synergy targets, obviously you mentioned that you feel confident that you can get over the $150 million net by the end of this year. I think you've talked about some of those synergies being volume-related. So maybe can you just comment on, you know, your confidence? Is that because, you know, you're seeing that volume improve or are you seeing, you know, maybe faster footprint reduction than you were anticipating? And then if you can talk at all about maybe the upside to that $250 million, you know, since you've mentioned that you'll achieve that earlier than you had previously anticipated.

Yeah, I would certainly say number one reason for that is, We do have a pipeline of synergies that's greater than the one that we've provided. So we're continuing to work on those, and they're critical in order to offset any alcohol downside that we could experience along the way. So we are not giving necessarily any considerations on volume growth at this point as being able to accelerate that. I think we've got good momentum there, and I think we continue to have opportunity here to provide all better news in terms of accelerating synergies as we progress this year and into next year. Okay, great. Thank you.

The next question is from Ken Hoekstra with Bank of America Merrill Lynch. Please go ahead.

Hey, good morning. Pat, maybe just continue on the margin commentary there. What are your thoughts on freight margins now that you've fully integrated with GE and lapping year over year? You're in the upper teens, but maybe just help us think about what happens as asset sales come back online. Should we see a mix change? Do you expect that to move back into the 20s? Should it stay at this level? Maybe just your general thoughts as the mix shifts with the business mix.

Sure. I mean, when you kind of look at the impacts, you have freight car builds that are really at very historically low levels. You have, you know, North America locos and the impact of that market on our business. You know, as those volumes come back on, we obviously get really good margins on the on the freight car build, and we get good margins on the locomotive builds, on OE, and the absorption that comes along with that. So I think that you could see the business and the margins for that freight segment improve with the higher volume. It certainly makes sense. The other aspect of this will be digital electronics and the investment that our customers make make and the growth in that revenue area will also provide really good margins for the segment.

So it's not like digital has higher margins because of less asset intensity, so therefore it's peakish now and with more assets it would be pressured, you see, as the physical assets come back and improving in that margin just as you get more fixed cost coverage?

Yeah, exactly. I think the fixed cost coverage is a big part of it, but I think it's also – those are good product lines for us, and they deliver a lot of value for our customers, and I think that as the overall volumes recover and we get industry improved, I think that you'll see the margins get back to more historical and typical levels.

And then for my follow-up, Pascal, obviously Freight did well in holding up in the backlog. Can you talk about the mix of contract services versus equipment in the backlog itself in terms of what was added and maybe your thoughts on domestic versus international as well?

Luke, you want to think about that? I just want to be a little careful. You know, I don't think we've kind of broken out like each of the component, the product line revenue into its backlog and everything. Obviously, we talk in general about the revenue mix in services as about half of it comes under the MSA agreements, which is an element of both labor service and parts and other activity. You have mods in there and you have part sales in there. So Those are basically the rule of thumb that we've been talking about in terms of how to look at that product line revenue. I think the orders that have come in kind of hold with that mix. It's not absolute every quarter, but when you look over a longer period, a year or more, you're going to see your order intake be pretty consistent with that mix of revenue.

Maybe To your question about... Go ahead. Now, to finish on your question about North America versus international, I mean, what we see is that in North America, we've seen this big impact from parking. Now, if you look at the active fleet today, WAPTEC locomotives really represent the majority of the fleet that is running today. So this is an effect that is mitigating this high parking number. And the locomotives that are running are running really hard. So in terms of megawatt-hour, miles per locomotive, We've really seen a strong increase together with the implementation of precision scheduled railroading. So this is one thing that is accelerating scheduled maintenance that is putting more focus on reliability, and this is good for service. International, Rafael discussed it. I mean, Australia is strong. Brazil is strong. Kazakhstan, Egypt. Many of our big international markets have remained strong. And in terms of mods, with the great work that our supply chain team has been doing to keep our factories open, we've been able to stick to our delivery schedules and to have a strong quarter as well. So these are really the three building blocks that can explain this performance, I would say.

I think if you look at the last few years, we've continued to see an increase in terms of the percent of our fleets running when compared to our competitors, whether if I look at North America or global markets. I think that's an ongoing trend.

Thanks, guys.

Appreciate the time. Thank you. Our next question comes from Matt Elcott with Cowan. Please go ahead.

Good morning. Thank you. So back at the analyst day, you guys provided a chart showing the installed base distribution for locomotives. And, you know, based on the age profile of the T4 locomotives, it would appear that some of them may be rolling off warranty in the next couple of years. First of all, is that Does that make sense? And if so, would that be a positive for aftermarket revenue on those locomotives?

Yeah, yes, that's true. Now, keep in mind, I mean, this is a big fleet, right? We are talking about 23,000 assets as we presented. I think we have a favorable age distribution. The average age of this fleet is only 13 years. So this is a pretty young fleet that is going to keep running for a number of years. You have some of the older fleets that are running less. You have some of the fleets that are coming off warranty, especially internationally. And so you have a number of effects coming together. But true, we have some locomotives coming off warranty, and these locomotives start generating service revenue.

And service revenue, that doesn't make it into the backlog number, does it? You publish at $12 billion.

Not necessarily. It depends on the contractual coverage that we have for these units.

Yeah, I mean, you have MSAs that are out there, depending on the customer and the fleet and their own decision. There might be a contract agreement that's in place, but you could also have customers be doing some of the maintenance on their own with just our parts or somewhere in the middle. It's really not... something that you can kind of paint a broad brush over everybody, it can be a little bit different. And that's why I always go back to kind of the mixer of the service revenue for the product line.

So there's about, what, $600 million, which is more transactional, which is orders you get on the go. So you might not be seeing those on the backlog, to your point, out of the total $2.2 billion that make up the business.

That makes sense. And, you know, speaking of a question that may be in a gray area and somewhat hard to answer. I was just wondering if we can gauge what percentage of your international backlog may be for customers that are government-backed entities federal government-backed entities versus, you know, state-level versus private companies. I know that you probably don't have that specific breakout, but any caller would be helpful.

I mean, exactly. We don't really have that breakdown like you described, but, I mean, I'm certainly looking into that and try to get back to you with at least some caller around it.

Yeah, I would just add, I mean, just as a, you know, like a rule of thumb or something just to consider. I mean, a lot of our, especially in the freight side, our contracts are backed with bank guarantees and other financing that's in place. When you get on the transit side, especially on the OE markets where you have the big backlog, those are typically supported with government funding, and often that funding has been in place for years because the contract was awarded years ago. So that's just kind of a thing to consider.

So that's one side on the equipment, and maybe on the service side, they will very often be sold if a service is contracted. on the top of that because they want to make sure ultimately they maintain the locomotives running and there's an element of continued training to the operators. What we often see is our fleets running, especially in those remote locations as we support the customer throughout the life of the locomotives.

Absolutely. Internationally, we can We can pretty often, without the proper service support, end up with a brand-new fleet of locomotives that is stranded after a few years only. We really try to stay close. We have our customers over the entire life of the locomotive. We have more than 160 service locations all around the world. So having local presence and being able to bring engineering support, whether physically or physically, with remote diagnostics is having keeping parts locally is really important for us internationally.

So we're very interconnected with our customers to the point that in a lot of places we manage the inventory associated with parts coming in and ultimately making sure we guarantee the availability and reliability of those assets. So we feel very much upfront any of those changes.

Great. Very helpful. Thank you very much.

Our next question comes from Jerry Ribich with Goldman Sachs. Please go ahead. Hi. Good morning, everyone.

Good morning. Rafael, I'm wondering if you could talk about how your MSAs performed in the quarter. Obviously, really strong services results. Sounds like mods helped. But can you talk about the MSA performance in particular? And, you know, I believe you get, higher revenue opportunities post-PSR adoption, and I'm wondering, are you starting to see that hitting the sweet spot, if you will? Can you just expand around those points?

Okay. So I'll just start with the second quarter. I mean, of course, the trends were not great there. I mean, we saw a decline in some of these items, and I think I mentioned about parks. I mean, we also saw pressure on MSA. I mean, units just not running as much as they were. But once again, I think as you start seeing the on-parking take place, I think we're seeing those trends as early as of June and continuing to July to move in the right direction. And I think we're seeing a good pattern from this point of view. But I think the one thing I want to highlight to you here is We're working with customers to make sure that they've got ultimately, I think, the most efficient, the most reliable locomotives out there. And this presents to us opportunities to overhaul, to modernize, and to ultimately also equip them so they can run a lot of the things you've heard from the class ones. How do I run longer trains? How do I get to a more fuel efficiency for those locomotives? And we've got to make sure that we're competitive as we do that. But things like distributed power with local control, LXA, trip optimizer, these are some of the technologies that will enable that. And these are, in fact, proven technologies that align very well with PSR and all the efficiency railroads want to drive. And I think, again, very much connected with a lot of the story you hear from Pascal on the services side. and one area that we continue to see opportunity here to grow our installed bays and to help customers with great paybacks.

Okay. And then, you know, a follow-up on mods. You know, Pat, I think you mentioned your prayer remarks. You had double-digit growth. You know, to hit the type of outperformance that you had in services versus freight volumes in the quarter, it would seem – Mods shipments would have to be up, you know, 30% to 40% year-over-year to drive the level of that performance. But we saw for you folks in the quarter in the morning, if you can comment on what's the inquiry level like for adding mods to backlog? You know, are you able to essentially maintain the mods backlog as we hopefully see improving freight conditions entering 2021?

Yeah, so the mods are, you know, they're in the backlog year over year. Essentially, we continue to execute on orders received in, you know, it would have been in 2019. And according to the schedule that our customers have worked with us on establishing. So there's a certain amount of quarter-to-quarter variability that will come with those mods orders as we execute. Sometimes it's, you know, to look at it and say that it's going to be linear or have a trend there, you really have to look at a bigger picture, a bigger number of quarters or a year-to-date kind of number. So it just so happens that in the second quarter, you know, that backlog is more staggered compared to last year. When you talk about order intake for mods going forward, I mean, it's – I think that there's a lot of interest in our customers to continue to use this mod approach to leverage, especially in their PSR strategy and their fleet strategy.

Pascal, do you want to add to that? No, I mean, number one, I think if you look at the service number for the quarter, it was not 100% a mod story, right? As we explained, we had a difficult situation in North America due to parking. However, a big portion of our fleet kept running. Internationally, we saw some strong performance, and then we had a strong mod quarter in terms of deliveries. Now, looking forward for mods, I mean, we believe that this is a big opportunity for the railroad, which is fully in line with their strategy, as Raphael said, around Longer trains, more reliable trains, better economic performance. We have analyzed the fleet in a lot of details, and we have the opportunity to deliver big outcomes to our customers. So we are talking about 50% increase in eligibility, reliability improvement by more than 50%, 10% fuel efficiency improvement. The addition of all our suite of digital solutions, trip optimizer, local troll, LXA. And all this, you know, when you combine it together, we believe that this is turning into a very attractive investment proposition for the railroad. Now for them, in the end, it's a question of capital allocation, and they decide. I mean, we work hard to show them the value of our product, and we believe that there is a big opportunity to create value for the railroad and for WAPTEC at the same time.

You can and you will see big swings between mods and what I'll call new locomotive volumes quarter over quarter. Just keep in mind it's the same facilities that are doing the mods or doing the new units. And, of course, we tend to profile those to make sure we're driving good productivity at our plant. So there could be some significant changes on quarter over quarter number.

I think the seasonality effect is important, and you have modes, you have service, you have schedule, you have unscheduled maintenance, you have the overall profile. There is a seasonality impact, and you will see some ups and downs there.

Okay. I appreciate the discussion, and congratulations on a strong quarter. Thanks, everyone. Thank you.

The next question will be from Steve Barger with KeyBank Capital Markets. Please go ahead.

Hey, thanks. Good morning. Just a couple of quick ones. For the digital business increase of 4%, more recurring revenue from existing customers, or have you been able to convert new customers looking for efficiency in 2Q?

Peter, you broke up a little bit. Steve, can you say it again?

Yeah, sorry. The digital business increased to 4%. More recurring customers, or were you converting new customers?

I think a lot of it's associated with what I'll call existing customers. We have the opportunity here to grow our install base on some products that are still under-penetrated. I think I mentioned here LXA as a product. I mean, we still have an install base that's relatively small when I look at the potential of this product. And it's a key product, especially as railroads look at making longer trains. I think there's some elements here of other products like Smart HPT, that will also enable customers to get significant fuel savings as they run those longer trains. More with existing products and existing customers. I think one of the big opportunities we have is to expand that share growth and really into the international markets. I think we've got some earlier adopters in places like Brazil, in places like Kazakhstan, but we can still be doing a lot into some modern geographies.

So that was my next question. The digital business is much more North America and less penetrated in international?

Exactly. Okay.

And just last one, one quick clarification. Slide 8 says you expect to drive margin improvement in transit through the rest of the year. Does that mean sequential improvement by quarter, or is that relative to what you put up last year?

I think, again, what I said last year was we're going to drive at least 100 base points margin improvement year over year, and we certainly have actions that support more than that. And I think my commentary earlier was – You look at the first half of the year, we're very much on track to do so. And actions will continue. It's less about even I'll call it improvement year over year, but making sure that we continue to drive momentum to get to our entitlement. So I want to see continued momentum there. Understood. Thank you.

The next question will come from Scott Group with Wolf Research. Please go ahead.

Hey, thanks for the time, guys. A couple of quick ones for you first, Pat. So typically third quarter, just normal seasonality is lower than second quarter. Does that sort of normal seasonality apply this year? And then maybe just bigger picture when I look at the guidance, sort of a faster improvement in revenue growth off the bottom than earnings growth? Maybe just some thoughts there on sort of the mix or margins as revenue starts recovering. Thank you.

Yeah, so the seasonality, you know, we kind of find that to be a little bit challenging and a little bit, you know, not typical year to year when you would consider all that we've gone through. You know, the easy one to point to is the timing of some of our freight services business. We would see a a lot of strength of that in the third quarter. And in my earlier remarks, I kind of mentioned that we see some of that edging out into the fourth quarter, and I think that that's, you know, from what we can tell with our customers, we think that that's going to have an impact. I think you also look at the – that was always, you know, kind of a positive seasonality in Q3. You also had some negative impact of shutdowns and plant – slowdowns in the summer months in Q3. We're seeing that being a little bit moderated. So I think that that's the expectation for us in Q3 with getting back to normal next year. And your point about kind of revenue growth, outpacing the earnings growth, I think that that's A little bit related to the sales mix, timing, we certainly will see some kind of return to normal in some of our engineering costs and SG&A being more consistent with the higher revenues, and I think that will have an impact on our margins a little bit in the second half of the year.

Okay, thank you. And just last one, if I go back to the beginning of the year, Pat, you were talking about $900 million of cash from ops. It looks like the net income guidance is down around $200 million from January. So should we assume a similar sort of $200 million decline in cash flow from operations, or is there reasons why it can be better than that?

Well, I think you've got to obviously consider the impact on net income and the lower volumes on the cash flow. But the areas of confidence in cash flow and opportunities to do better really starts with the ability to work with our working capital, to reduce our working capital with the lower volumes, turn that into a source of cash. obviously the cash, the cost savings initiatives that we put in place. And, you know, we continue to execute on some of the tools, the balance sheet tools and the supply chain tools that we replaced from exiting the GE transactions. So all those things, I think, lead to a lot of confidence in our cash flow generation for the rest of the year.

Okay, great. Thank you, guys. Appreciate the time. Thank you.

Ladies and gentlemen, this concludes our question and answer session. I would like to turn the conference back over to Christine Kubacki for any closing remarks.

Thank you, everyone, for your participation. I will turn the call over to Rafael for a quick few comments.

Hey, just one of the most disruptive quarters for us ever with really an impact for both customers and operations. WAPTAC employees have been absolutely amazing in their response. And I just want to thank them for the hard work and dedication to keep serving our customers and running our company well. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.