Allison Transmission Holdings Inc

NYSE:ALSN

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's Second Quarter 2018 Results Conference Call. My name is Rob, and I will be your conference call operator today. At this time, all participants are in a listen-only mode. After the prepared remarks, the management from Allison Transmission will conduct a question-and-answer session and conference call participants will be given instructions at that time. As a reminder, this conference call is being recorded.

I would now like to turn the conference call over to Ray Posadas, the company's Director of Investor Relations. Please go ahead, sir.

[Raymond Posadas, Allison Transmission Holdings, Inc.]

Thank you, Rob. Good morning and thank you for joining us for our second quarter 2018 results conference call. With me this morning are Dave Graziosi, Allison Transmission's President and Chief Executive Officer; and Fred Bohley, Allison Transmission's Vice President, Chief Financial Officer and Treasurer. As a reminder, this conference call, webcast and presentation we are using this morning are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through August 7.

As noted on page 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These forward-looking statements are subject to known and unknown risks, including those set forth in our second quarter 2018 results press release and our Annual Report on Form 10-K for the year ended December 31, 2017, and uncertainties and other factors as well as general economic conditions. Should one or more of these risks or uncertainties materialize or should underlining assumptions or estimates prove incorrect, actual results may vary materially from those that we express today.

In addition, as noted on page 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached as an appendix to the presentation and to our second quarter 2018 results press release. Today's call is set to end at 8:45 AM Eastern Time. In order to maximize participation opportunities on the call, we'll take one question from each analyst. Please turn to slide 4 of the presentation for the call agenda.

Now, I'll turn the call over to Dave Graziosi.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Thank you, Ray. Good morning, and thank you for joining us. During today's call, I'll provide you with an overview of our second quarter results including net sales by end market. Fred Bohley will then review the second quarter financial performance and the 2018 guidance update. Finally, I'll wrap up the prepared comments prior to commencing the Q&A.

Before I begin, today's call marks the first time I am addressing you as Allison CEO. I am both humbled and honored to succeed Larry Dewey and will hold the standards and record of performance he established that separate our company from virtually any other industrial enterprise. I like to again thank Larry for his leadership through an unprecedented period of change, while positioning Allison for continued and long-term success.

I'd also like to welcome Fred Bohley as our new CFO, whom I have worked closely with during my tenure at Allison. Fred has been instrumental member of our organization for many years and I am confident in his ability to continue pursuing our vision and living our values in his new role. It's an exciting time to be part of Allison in our industry. As we often have said, our strengths are derived from our proven ability to leverage our most valuable assets, our people, our technology, our manufacturing capabilities, and our unrelenting focus on creating value for our customers.

I believe our businesses and the talented and dedicated men and women, I am privileged to lead, are well positioned to realize the opportunities that lie ahead; continue the heritage of leadership in the markets we serve and in the communities where we live and work, and deliver the value and performance that our customers and stakeholders have come to expect.

Turning to the quarter, we are very pleased to report that Allison achieved record net sales of $711 million in the second quarter of 2018. Net sales for the quarter increased 23% from the same period in 2017, driven by increased demand across all of our end markets and the execution of growth initiatives throughout our business.

Year-over-year net sales growth were surpassed by even stronger growth in net income up 83% and adjusted EBITDA up 32%. Additionally, our established and well-defined approach to capital structure and allocation remained intact. During the quarter, Allison settled $244 million of share repurchases, repaid $25 million of long-term debt and paid a dividend of $0.15 per share.

Please turn to slide 5 of the presentation for the Q2 2018 performance summary. As I just mentioned, net sales increased 23% from the same period in 2017, principally driven by higher demand in Global On-Highway, Global Off-Highway and Service Parts, Support Equipment & Other end markets. Gross margin for the quarter was 52.6%, an increase of 260 basis points from a gross margin of 50% for the same period in 2017, principally driven by favorable net sales and price increases on certain products, partially offset by unfavorable material costs.

Please turn to slide 6 of the presentation for the Q2 2018 sales performance summary. North America On-Highway end market net sales were up 9% from the same period in 2017, principally driven by higher demand for Rugged Duty Series model. North America Off-Highway end market sales were up $26 million from the same period in 2017, principally driven by higher demand from hydraulic fracturing applications. Defense end market net sales were up $13 million from the same period in 2017, principally driven by higher Tracked and Wheeled demand.

Outside North America On-Highway end market net sales were up 19% from the same period in 2017, principally driven by higher demand in Asia and Europe. Outside North America Off-Highway end market net sales were up $14 million from the same period in 2017, principally driven by higher demand in the energy, mining and construction sectors. Service Parts, Support Equipment & Other end market net sales were up 24% from the same period in 2017, principally driven by higher demand for global service parts and support equipment.

Now, I'll turn the call over to Fred.

[G. Frederick Bohley, Allison Transmission Holdings, Inc.]

Thank you, Dave. Please turn to slide 7 of the presentation for the Q2 2018 financial performance summary. Given Dave's comments, I'll focus on other income line items and adjusted EBITDA. Selling, general and administrative expenses increased $5 million from the same period in 2017, principally driven by higher warranty expense commensurate with increased net sales, partially offset by lower incentive compensation expense.

Engineering – research and development expenses increased $8 million from the same period in 2017, principally driven by increased product initiatives spending. Interest expense net increased $3 million from the same period in 2017, principally driven by the interest expense associated with our 4.75% senior notes due October 2027 that were issued in the third quarter of 2017, partially offset by 2017 interest expense from interest rate derivative contracts that were terminated in December 2017.

Other income net increased $8 million from the same period in 2017, principally driven by net periodic benefit credits related to post-retirement benefit plan amendments and 2017 technology-related investment expense that did not recur in 2018. Income tax expense for the second quarter of 2018 was $48 million, resulting in an effective tax rate of 22% versus $51 million of income tax expense and an effective tax rate of 35% from the same period in 2017. The decrease in effective tax rate was principally driven by the U.S. Tax Cuts and Jobs Act enacted into law in December 2017.

Net income for the second quarter of 2018 was $174 million compared to $95 million from the same period in 2017. The increase was principally driven by increased gross profit, partially offset by increased product initiatives spending and increased selling, general and administrative expenses.

Adjusted EBITDA for the second quarter of 2018 was $297 million or 41.8% of net sales compared to $225 million or 38.8% of net sales for the same period in 2017. The increase in adjusted EBITDA was principally driven by increased net sales, price increases on certain products, partially offset by increased product initiatives spending, increased selling, general and administrative expenses, increased manufacturing expense commensurate with increased net sales, and unfavorable material costs.

Please turn to slide 8 of the presentation for the Q2 2018 cash flow performance summary. Net cash provided by operating activities increased $47 million from the same period in 2017, principally driven by increased gross profit, partially offset by increased defined benefit pension plan funding payments, increased cash income taxes, increased product initiatives spending and increased cash interest expense. Adjusted free cash flow increased $40 million from the same period in 2017, due to increased net cash provided by operating activities, partially offset by increased capital expenditures.

As Dave mentioned earlier, during the second quarter Allison continued executing its well-defined approach to capital structure and allocation by settling $244 million of share repurchases, repaying $25 million of long-term debt and paying a dividend of $0.15 per share. Also during the quarter, Allison entered into interest rate derivative contracts totaling a notional amount of $500 million resulting in $1.9 billion of fixed rate long-term debt inclusive of our 2024 and 2027 senior notes or nearly 75% of total long-term debt.

More recently, Allison's board of directors approved a new authorization under the company's current stock repurchase program for the repurchase of up to an additional $500 million of outstanding common stock. The new authorization brings the total amount authorized under the program to $2 billion; additionally, the termination date of the program was removed.

Finally, we ended the quarter with a net leverage of 2.4, $96 million of cash, $533 million of available revolving credit facility commitment and $184 million of authorized share repurchase capacity, not including the $500 million increase approved by the board.

Please turn to slide 9 of the presentation for the 2018 guidance update. Reflecting on the strong first half 2018 results and current end market conditions, we're updating our full year guidance as follows: net sales up in the range of 15% to 18%; net income in the range of $570 million to $600 million; adjusted EBITDA in the range of $1,040 million to $1,080 million; net cash provided by operating activities in the range of $765 million to $795 million; capital expenditures in the range of $85 million to $95 million; adjusted free cash flow in the range of $670 million to $710 million; and cash income taxes in the range of $90 million to $100 million.

Allison's full year 2018 net sales guidance reflects increased demand in the Global On-Highway and Global Off-Highway end markets, price increases on certain products and the continued execution of our growth initiatives. Although we are not providing specific third quarter 2018 guidance, Allison does expect third quarter net sales to be up from the same period in 2017, principally driven by increased demand for Global On-Highway products.

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

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Thanks, Fred. Before we conduct the question-and-answer session, I'd like to spend a few minutes reviewing our strategic priorities. As I said earlier, right now is an exciting time to be part of Allison and our industry as a whole. As our business enters its second century, meaningful and profitable growth opportunities exist across all of our end markets. There is also more rapid change in our industry and more Allison initiatives underway today than at any point during the last decade.

Given such an elevated level of change in activity, we will focus with a high sense of urgency on that which can be controlled and the following strategic priorities: resolute pursuit of our vision, delivery of our brand promise, and adherence to our values. We'll maintain a consistent focus on profitable growth opportunities, a legacy of execution, constant improvement and acting in the best long-term interest of all of our stakeholders.

We'll keep our products relevant by developing technologies and propulsion solutions that customers value and further differentiate Allison. We'll also foster our corporate culture that embraces challenges and responds quickly to changing end market needs. Our customers' priorities are our priorities. And finally, close integration of Allison with a continued evolution of its end market.

We'll pursue these strategic priorities while proactively aligning costs in programs across our business with actual end market conditions and growth initiatives. Most importantly, despite Allison's extensive and successful operating history, we will continue to test ourselves and never accept the viewpoint that we are too successful to set another goal or imagine a better reality.

Finally, Allison competes in a complex and fragmented space, requiring a range of propulsion solutions where we are a natural supplier. From conventional internal combustion drivetrain to alternative fuels and from electric hybrid systems to fully electric solutions, the combination of our experience and expertise, vocational knowledge and product planning discipline uniquely positions Allison to remain a leader in our industry.

This concludes our prepared remarks. Rob, please open the call for questions.

[Operator]

Thank you. We'll now be conducting a question-and-answer session. Thank you. The first question today comes from the line of Jamie Cook with Credit Suisse.

[Jamie L. Cook, Credit Suisse Securities (USA) LLC]

Hi. Good morning and nice quarter. I guess, Dave, can you just give us some more color on your updated 2018 guidance? How you're thinking about sales growth by the different segments? And to what degree is your 2018 forecast constrained by your customers' inability to ramp demand further? And are there any markets where you see better visibility into 2019? Thanks.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

You're welcome. Good morning, Jamie. So a couple of things. In terms of the sales guide update as we see the second half playing out, certainly North America On-Highway, I'll go through the end markets that we expect the high vocational demand to continue in the second half consistent with third-party forecasts. I'm also confident that you gathered from other public reporting and comments that commercial vehicle market continues to be constrained at some level by component supply issues rather than demand.

That's particularly challenging and certain low volume models. As we pull together, our forecasts certainly have assumed that that does not worsen in the second half. I would note that some OEMs have commented about expecting some level of improvement versus the first half. I guess, you can look at that in a number of different ways. We're certainly staying close to supply constraints across our business, as we mentioned on the first quarter call, there are a number of issues there.

But I would tell you that it's again focused more so on our lower volume models, in some cases, and then the broader portfolio. I am not aware of us creating issues relative to our Global On-Highway business with OEMs in terms of meeting for the most part their delivery schedules, again assuming that we are receiving forecast and staying rather close to our mindset requirements.

North America Off-Highway, again certainly higher demand from hydraulic frac as you know. We're expecting that to moderate a bit in the second half to be materially consistent with the elevated level in 2017. So as we think about how we entered 2018 and have ramped from 2017, we would expect to see that type of level in new unit sales for North America Off-Highway.

I know there've been a number of comments from some public reporting around some constraints there. Again, as I said earlier, that's not inconsistent with the point about lower volume units. As you know, Off-Highway does not have very high units, so typically lower volumes with higher average selling prices. Defense, we're expecting higher Tracked and Wheeled demand with the second half expectation for continued strength in Tracked demand, relatively flat on the Wheeled side.

Outside North America On-Highway, higher truck demand in Europe and Asia. I think that's been broadly the story for the year so far, with overall expectations that truck will be up and bus down for the year outside North America. But I would expect that again to see some level of moderation in the second half to a level materially consistent with 2017. We are executing growth initiatives, as we talked about – referred to in the prepared remarks a number of initiatives we believe are getting traction. I think the team is doing a good job executing there, but I think I would also say some of that is rather early days. As you know, it takes quite some time, many cases to secure growth in this market.

Outside North America Off-Highway, with the higher demand that we're seeing across all of the sectors, we expect that to continue in the second half. And again, that assumes no further deterioration in component supply availability. Finally, Service Parts, Support Equipment & Other, higher demand for global service parts and support equipment, we would expect to moderate a bit in the second half, again materially consistent with the elevated level in 2017.

[Jamie L. Cook, Credit Suisse Securities (USA) LLC]

All right, and thank you. I'll get back in queue.

[Operator]

Our next question is from the line of Mike Baudendistel with Stifel. Please proceed with your question.

[Michael James Baudendistel, Stifel, Nicolaus & Co., Inc.]

Great. Thank you. Just wanted to see if you could give us a little bit more detail on the ramp in engineering and R&D costs, sort of what types of products are you developing?

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Sure. This is Dave. Again, I believe we talked about on the first quarter call where we are investing across our entire product range in all of our end markets. So, it is not isolated to one particular thing. So I would tell you without getting into our detail there, it's broadly based. And I would tell you that there is a fair bit of work that the team is doing with our marketing sales and service colleagues relative to the voice of customer around future technology roadmaps, product roadmaps, et cetera, I would say.

More so now, just given the number of propulsion solutions that are being worked, it becomes that much more important to stay close to the end markets; and frankly, customer planning. So, it's broad based. I would certainly tell you, with Hannover coming up in September, we have a number of plans there in terms of starting to talk to what we've been working on to a degree; there's others that will be updating the market on. But I would say, broadly-based investments there.

I would also tell you in terms of expectation on spending. If you look at the Q2 level versus our expectations for Q3 and Q4, we would expect Q3 and Q4 to be slightly higher than Q2 at this point. Again, that's all subject to development and sourcing milestones. But the team is very engaged and certainly pleased with their efforts.

[Michael James Baudendistel, Stifel, Nicolaus & Co., Inc.]

Got it. Thank you.

[Operator]

The next question is from the line of Ian Zaffino with Oppenheimer. Please proceed with your question.

[Mark Zhang, Oppenheimer & Co., Inc.]

Hi. Good morning, guys. This is Mark on for Ian. I just want to sort of drill down on your implied adjusted EBITDA margin guidance. It seems it was primarily raised on the low end – from the low end. Would you guys be able to provide some primary drivers of where that will be? Is that from stronger leverage on increased top line or expect to reduce sort of operating costs or some of the key areas, if you could highlight, it would be great. Thank you.

[G. Frederick Bohley, Allison Transmission Holdings, Inc.]

Sure, Mark. Thank you. This is Fred. The primary driver obviously is the increased top line and the operating leverage. As we do look out over 2018 at this point from a price standpoint, we expect – we talked about 50 basis points on the last call. At this point, I think it's looking closer to 50 to 100 basis points on a full year basis. Material cost hasn't changed meaningfully. We've seen some slight uptick obviously in raw, but we've got some good programs in place with our suppliers to offset those raw increases. So again, the primary driver is going to be the operating leverage from the top line growth and then some additional price.

[Mark Zhang, Oppenheimer & Co., Inc.]

Great. Thank you, guys, very much.

[Operator]

The next question is from the line of Seth Weber with RBC Capital Markets. Please proceed with your question.

[Seth Weber, RBC Capital Markets LLC]

Yeah. Hi. Good morning. Thanks. I just wanted to ask about, there has been a pretty big increase recently in some of the industry data in the cancellation rates for the straight truck market. I was wondering if you had any thoughts about kind of what customers are doing from an ordering or cancellation perspective. If you have any views as to, if this is just kind of – if industry demand is sort of – kind of as advertised or if there's something going on that you're seeing or you're hearing just from a ordering and cancellation perspective that you would call out or that you still feel is kind of in good shape? Thanks.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Good morning, Seth. This is Dave. Couple of things in terms of your question. As you've seen from the OEM reporting here over the last week or two, their order boards apparently are pretty full. I would also tell you that part of that process that's underway, as we understand it is trying to squeeze what we call water out of the schedule. So depending on the OEMs, there's different ways to do that. But I will certainly tell you, our understanding is there is a number of initiatives that are underway to really push firming up schedules for this year; and frankly, would appear to be pushing some volume into next year already.

So, to your point in terms of cancellations, I think that's – frankly, some of that is just an outcome of trying to rationalize what's happened in the market. The other thing that we stay close to amongst a few others is inventory levels across the board. So whether it's at the retail level or even with OEMs themselves, parked vehicles, et cetera, or waiting parts (00:26:43), the fact is there is a fair bit of activity out there, we're spending more time on that because our experience with markets like this, whether they're ramping significantly or unfortunately going in the other direction, is a level of awareness there in terms of what's happening to manage our business and the ultimate – ultimately the balance of the supply chain.

But I would say, there is a lot of work that's going on as I mentioned with suppliers and constraints. And the fact is, as you may resolve one thing, you typically find there's others. We're at unprecedented levels as an industry right now, so that's not surprising. And I would expect as the year rolls out and OEMs and customers get more pointed about what's actually going to happen going into next year that you're going to continue to see some level of orders, whether that be cancellations, backlogs, et cetera, but there's going to be a fair bit of work to do to firm up that board going into 2019.

[Seth Weber, RBC Capital Markets LLC]

Okay. Thanks, Dave. And then just so sitting where you are today, it sounds like you feel pretty good about the outlook into 2019 relative to where we were last year and looking into 2018 at this point. Is that a fair characterization?

[David S. Graziosi, Allison Transmission Holdings, Inc.]

I would say this that I would certainly – I prefer the position that we're in now in terms of broader industry outlook. That being said, that's based on the OEMs public comments. So I'll let them continue to speak for themselves and we are prepared and positioned to deliver whatever their requirements are and support them in any way we can. But we'll await and see what happens here as we get later in the year as we always like to say, our forecast seems to grow in terms of confidence as we get later into the year. So, we shall see. But in the meantime, the team here is going to continue to do everything they can to support our customers and end users and be prepared to supply.

[Seth Weber, RBC Capital Markets LLC]

Okay. Thank you very much. Appreciate it, guys.

[Operator]

The next question is from the line of David Leiker with Robert W. Baird. Please proceed with your question.

[Joe D. Vruwink, Robert W. Baird & Co., Inc.]

Hi. Good morning. This is Joe Vruwink for David.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Good morning, Joe.

[G. Frederick Bohley, Allison Transmission Holdings, Inc.]

Good morning, Joe.

[Joe D. Vruwink, Robert W. Baird & Co., Inc.]

It seems like you guys have been announced and associated with a fair number of these new Class 4 or 5 trucks coming to market in the back half of this year. Can you maybe just help quantify the market opportunity as you see it? So based on your releases, what sort of volume you potentially are looking at? And then in the 2019, as you get a full year worth of volume, what sort of market share could you capture of that Class 4 or 5 opportunity?

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Joe, it's Dave. Couple of things. So you know our history prior to GM stepping away from the medium-truck business, we had upwards of 10%-plus of that Class 4 or 5 space at that time. So frankly, I can't speak to specifically the OEMs plans. We'll let them do that. I would say, our expectation is, we would certainly target moving back to that level over time, again subject to the OEMs releases. And frankly, the marketplace's positive reaction to their vehicles.

We are, as we talked before, certainly prepared to deliver in the timing that's been communicated to us; at the same time, it's a competitive marketplace that they're moving into. So we'll stay close to that. We've done a fair bit of product development in a number of ways. The team here to further improve our offerings and make them perform in a way that end users are certainly happy with performance as best we could tell, but we continue to improve that relative to the competition.

And I would expect that the alliances that we've created with the relevant OEMs will deliver the types of volumes that we're ultimately used to having in the past. Other than that, I think it's really going to come down to again net-net timing here as we get into later this year and early 2019 on what we'll see. And I'm sure we'll be having this conversation next year in terms of a firmer view on run rate.

[Joe D. Vruwink, Robert W. Baird & Co., Inc.]

Okay. Great. Thank you.

[Operator]

Next question is from the line of Tim Thein with Citigroup. Please proceed with your question.

[Tim W. Thein, Citigroup Global Markets, Inc.]

Great. Thank you. Good morning.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Good morning.

[Tim W. Thein, Citigroup Global Markets, Inc.]

I just – good morning. Yeah. Just Dave, to go back to your comments and digging into the guidance a little bit more. Just on the parts segment, specifically if I said – just kind of thinking about On versus Off-Highway, would it be fair based on the comments to assume about, call it, a 30%, I'm just thinking Off-Highway first half versus second half, roughly 30% lower in the back half. Is that kind of what the guidance implies? Am I in the zip code on that?

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Yeah. We're I think in the range there as we thought about. And again, lot of variables moving around in that market right now for a number of reasons, whether it's constraints on the end user side in certain areas with consumables and transportation and all the other things that everybody is focused on.

That being said, I think the way we viewed first half, second half to your point there, there is certainly a more of a moderation, shall we say, than if you look at the first half. And I would draw – reference back to what we saw in the second half of last year and starting to moderate a bit off of that range, as you know, the ramp rate. But the fact is, we expect the upgrades as we've talked before to be coming to some level of event (00:32:42) there, they'll move into normal overhauls and then new units also.

So, I don't think it's playing out significantly different from what we've said on the first quarter call. But again, a lot of assumptions there in terms of end users, take rates, as well as some of the supply constraints to be managed.

[Tim W. Thein, Citigroup Global Markets, Inc.]

Okay. Understood. Thank you.

[Operator]

The next question is from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.

[Jerry Revich, Goldman Sachs & Co. LLC]

Hi. Good morning, everyone.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Good morning, Jerry.

[Jerry Revich, Goldman Sachs & Co. LLC]

Dave, Fred, can you talk about as you think about scenario planning whenever the market environment softens, what level of decremental margins are you folks thinking about? Can you just give us a sense for the levers that you would pull eventually when the market does eventually soften? Your margins are up significantly cycle-over-cycle, so we saw strong leverage on the upside. And I'm wondering if you can share with us your playbook for when the market slows and what kind of margin progression you're planning in that scenario?

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Yeah. Jerry, it's Dave. A couple of things. We have the unfortunate or fortunate experience depending on how you look at of addressing reductions in volume, or if you think back basically 10 years ago now seems longer. But the idea is, what happens? The answer to your question is, we try to maintain, as I guess every business does, a relatively variable cost structure. So as you know, we typically manage outputs with manning.

So from a manufacturing perspective, I'm certainly reducing the overtime levels that we're currently running to keep that variability. We also have, as part of the business, as you know with the demographics we can manage a number of things in terms of broader manning issues through just attrition. So as we think about that side of the business in terms of cost structure, I think the team has positioned us well to be able to manage through that.

I would also tell you, as we've said in the past, we aligned our cost structure with the underlying end market conditions as well as growth initiatives. So as we think about it, it's like anything else. We look at the opportunities versus the underlying market conditions and can adjust, I would say, in a relatively flexible way. That being said, we stay true to our investment return targets; and frankly, delivering the brand promise. So, that goes into the mix, but I would say it's relatively variable in terms of decrementals.

Obviously, we're going to take some level of deterioration, shall we say, in the operating leverage we enjoy today which is relatively high. I would also tell you, there's supplemental cost in the numbers that you see today that we're trying to manage through with supply constraints as well. Raws are up. As we've talked about, there's a number of things that are embedded in the numbers, freight cost, et cetera. So when that market turns again, we should see some tailwind from those as well. But overall, it's a reasonably variable structure at that point and we will take appropriate steps.

[Jerry Revich, Goldman Sachs & Co. LLC]

So consistent with the gross margin level, is that the way we should be thinking about it?

[David S. Graziosi, Allison Transmission Holdings, Inc.]

We'll make certainly adjustments that presumes that the same overall mix of end markets, right, Jerry. It's going to be present. I think that's a bit of a stretch for me to think through. But I would say, generally speaking, you're going to take some level of deterioration there. It's just a question of how quickly can we adjust. I would tell you, we'll make appropriate moves with the market that are again responsible with a prudent management of this business over the cycle. And I think that's the part some people move away from in terms of – we don't ramp spending at the same time.

The cycle I would not look at our spending today as commensurate with broader market conditions. I will tell you that we are resourcing at a level commensurate with the opportunities that are there, but we think about the business over the cycle. So, we'll take appropriate steps with the variable pieces and adjust the balance of the structure.

[Jerry Revich, Goldman Sachs & Co. LLC]

Okay. I appreciate the discussion. Thanks.

[Operator]

The next question is from the line of Larry De Maria with William Blair. Please proceed with your question.

[Larry T. De Maria, William Blair & Co. LLC]

Hi. Good morning. Congratulations, Dave. Thanks for your thoughts on the direction of the company earlier in the call. Curious if you think specifically, your thoughts on the timing of the buyback, obviously, took the timeframe off of that, I guess, to keep it going. But can we execute that over the next, let's say, year and a half?

And secondly, are you – one thing you didn't mention was acquisitions in your prepared comments, I don't think. So I was just curious if you're thinking about embracing acquisitions, specifically with regards to electric vehicles to build out that portfolio. Thank you.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

You're welcome. So, a couple of things. So in terms of the buyback as you know and we said in the prepared remarks, our capital allocation policy and cap structure thoughts have not changed. Given the cash flow profile, the business; frankly, the guidance update, a number of other developments with the business, we feel it's critical to continue to support that policy and that allocation methodology. We also felt to maximize our flexibility to execute the authorization. There was really no need to have a time limit on that. So, I think the board prudently will maintain a high level of flexibility there and the team here executing subject to market conditions.

Having said all that, as we think about other opportunities to deploy the capital, I would certainly tell you the business today is different than it was a decade ago, the leverage that the business carried then was roughly almost 3x where we are today. So we do have the ability and I think frankly the interest level with our portfolio from a technology and products perspective, to think more broadly both internal investment as well as external. So, we have and continue to do both.

You'll recall that we've, over the years, purchased a number of technology licenses. I would not say that's different at some level from M&A type activity; it's a very pointed exercise, a very focused exercise. I would also say that as we think about the business and the number of propulsion solutions going forward to meet market needs, there are various ways to gain access to technology. It's also, I think, worthy of noting that the solutions going forward in many cases will require more combined activities by parties versus single-point type systems per se, just given the complexity of the components, the amount of investment that's being made, the diversification of risks that we would see alliances and partnerships from that perspective being probably more relevant than they have in the past.

Again, that can take on a number of different forms, but we reserve certainly our right to access that as best we can on behalf of our stakeholders to position this business for continued success across a range of propulsion solutions, and that goes from whether it's existing internal combustion right through to full electric.

[Larry T. De Maria, William Blair & Co. LLC]

Okay. Thank you very much.

[Operator]

Our next question is from the line of Ross Gilardi with Bank of America Merrill Lynch. Please proceed with your question.

[Ross Gilardi, Bank of America Merrill Lynch]

Yeah. Good morning, guys.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Good morning.

[G. Frederick Bohley, Allison Transmission Holdings, Inc.]

Good morning.

[Ross Gilardi, Bank of America Merrill Lynch]

Just on margins, I mean there's been these steady concerns for the last year that once you start to see a pickup in North America Off-Highway potentially at the expense of aftermarket, you'd see some margin dilution and that didn't really come to fruition granted the Off-Highway – that the parts business is still continuing to grow pretty rapidly. But is that mix shift maybe not as margin dilutive as we all might have thought? Or are there other factors aside from just volume leverage that would explain why your margins are so strong? So is there a big like counteracting factor in the bridge...

[G. Frederick Bohley, Allison Transmission Holdings, Inc.]

Hey, Ross...

[Ross Gilardi, Bank of America Merrill Lynch]

...tied to that potential margin dilution. Yeah. Thanks.

[G. Frederick Bohley, Allison Transmission Holdings, Inc.]

Ross, this is Fred. So if you think about mix for the quarter, relatively neutral. Obviously, revenue were up significantly. Our Off-Highway unit revenue was above average, which is positive from a mix standpoint. But Tracked defense was above average, which would be somewhat negative from a mix standpoint. On-Highway units were below average. So we look at the mix for the quarter as being relatively neutral. The strong driver there really is the operating leverage of the business. And as I mentioned, we did get some price in the quarter as well.

[Ross Gilardi, Bank of America Merrill Lynch]

Yeah. I want to ask you about that, Fred. So, is that pricing tied to – is that a cost push dynamic? Is that tied to expiration of contracts or supply and demand or technology? What actually is that additional price that you are able to gather?

[G. Frederick Bohley, Allison Transmission Holdings, Inc.]

We got about $5 million in price in the quarter, so similar to what we got in Q1. It's really not a cost push. We do have the commodity surcharges in place of our OEMs, where we pass through aluminum and three grades of steel. That shares – on about 90% of the North American long-term supply agreement business, it's about a 75% share. But that has a tendency to lag. There's about a six-month lag. So that's really not the driver. It's both transactional price to the OEMs as well, with the robust market less end user incentives.

[Ross Gilardi, Bank of America Merrill Lynch]

Got it. And then just lastly, Dave, just as you take over and you think about EBITDA margins, I mean we all keep thinking they're going to run out of gas and they keep going higher. I mean, what is – how are you thinking about margins over the next several years? Is it a priority for you to continue to grow EBITDA margins beyond 2018 versus reinvesting in the business and so forth? Really how much higher can EBITDA margins go?

[David S. Graziosi, Allison Transmission Holdings, Inc.]

On behalf of the Allison team, I'll apologize for disappointing everybody in terms of the increase in margins. To your point, we don't have an EBITDA margin target. And as we think about it, it's profitable growth. So the short answer to your question is, if we can grow this business with an appropriate return on capital for our investors and maintain – position the business for long-term continued success, we will invest accordingly.

So I would tell you, as we've talked about in the past, some of those growth initiatives by definition, depending on end markets, will certainly come in at less than mature selling prices, I would certainly argue. At this point, we are pursuing a number of different growth initiatives. So again, I would not necessarily fixate on a EBITDA margin outcome. I would think about it in terms of appropriate return on capital, growing the cash flow of the business and long-term positioning for our portfolio.

So I also would tell you, the investments whether they be internal or external, are not going to be linear as we think about a number of different outcomes here. We haven't ramped investment yet this year just to maintain and support our customers. So there's a number of things that we're doing across the board in terms of investment. And as other opportunities arise in the market, we'll pursue them accordingly. But again, I think we're obviously happy with the team's performance, but we're also investing some of that performance in growth.

[Ross Gilardi, Bank of America Merrill Lynch]

Got it. Thanks very much.

[Operator]

Our next question is from the line of Neil Frohnapple with Buckingham Research. Please proceed with your question.

[Neil Frohnapple, The Buckingham Research Group, Inc.]

Hi. Good morning.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Good morning.

[Neil Frohnapple, The Buckingham Research Group, Inc.]

For outside North America Off-Highway, revenue doubled sequentially albeit off a low base and you called out improving demand in energy, mining and construction. But could you just talk more about this and if there was any sort of timing of large orders that benefited the quarter? And I guess, more importantly, I think you talked about continued strength in the back half of the year. But I'm just trying to get at if the revenue level you experienced in 2Q is a good trajectory for the rest of the year? Thank you.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Neil, this is Dave. A couple of things. Outside North America Off-Highway, as you know, is more of a balanced portfolio across all of the sectors that I mentioned. Certainly, mining, construction have not ramped at the pace of energy in North America. I think frankly that's an advantage to see that outside North America. Typically it's more of a volatile book, especially in emerging markets. So we've stayed close to inventory levels throughout the channel including OEMs. And I would tell you that the numbers that we're seeing are relatively attractive in terms of hold levels and plans for the second half. So I don't think there is anything I would point to in the first half in terms of large tenders or volumes.

The fact is the team has been successful in several new releases with Volvo Construction Equipment as well as Bell on the 60-ton articulated dump. I think they've done a nice job executing there. I think the OEMs have been successful. The products are well received. The balance of it is, the broader market has stepped up. I'm sure you're aware of other public reporting that points to some of these levels. I think the debate seems to be now as where we are in the cycle.

I don't think we're late certainly, but I'd probably put us somewhere between early to mid, depending on the region, but the broader outlook continues to be favorable there. And frankly, given supply investments that are being made that type of ramp that we've laid out in terms of the guide is reasonably cost efficient for us as well and I think the industry, but something we're going to stay close to as we get into 2019 in terms of broader channel inventory levels.

[Neil Frohnapple, The Buckingham Research Group, Inc.]

Okay. Thanks very much.

[Operator]

Our final question today will come from the line of Rob Wertheimer with Melius Research. Please proceed with your question.

[Rob Wertheimer, Melius Research LLC]

Hey. Good morning, guys. If I can ask, I guess, kind of a strategic one for the last one. What's your experience in markets outside the USA, where fully automatic transmissions are not common and where you're working with OEMs and I'm thinking specifically to China, but maybe you could respond if you think there's another market that's more relevant.

So what's your experience in the desire of OEMs to sort of invest in this technology and bring it forward and realize the benefits versus they have an eye on electrification and maybe there's not room in the next 10 years to sort of slot this in before electrification takes over. I'm just curious what your development partners are thinking.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Rob, it's Dave. In terms of outside North America On-Highway fully automatic penetration, I guess to your question, it continues to be a regional approach right in terms of how we enter those markets and penetrate. It's a release-by-release process. I would tell you, we haven't had a tremendous amount of pushback on new releases, I think to your point. If they're favoring one propulsion solution versus another, that's not necessarily readily apparent to us.

I would say that there's – the OEMs are struggling in those markets as much as others in terms of getting economic solutions across the range propulsion solutions. So the fact is, the underlying issue of a need to move to a fully automatic product given the challenges with drivers, demographics, et cetera, and the value of vehicles continuing to go up, I think plays to the Allison value proposition. So we're comfortable in terms of where we are positioned.

I would say that it's never an easy thing to do, frankly also to be done already. So the team is working very hard on our growth initiatives. I would say, it's also continues to be an opportunity to engage with the OEMs on their technology and product planning relative to the range of solutions that they're looking for. I would also mention that it really depends on what region you're in. For instance, China, as you know, pushing the agenda on bus had some level of carryover as you would expect in truck. I think the challenge there for that market like any other is, how do you continue to support what I would affectionately describe as economic coercion to make things happen in a market where you have end users that aren't subsidized versus others that are subsidized.

I think that's a broader challenge when you start looking at the balance of the emerging markets, whether it's even India at this point or Brazil. The willingness to spend money on new technology very much gets back to initially subsidized applications and then does that move more broadly through regulatory pressure. And we're seeing that across all of the markets now in terms of the way OEMs are trying to do their planning, but we're comfortable that there is plenty of opportunity for our product in the emerging markets. It's just literally a release-by-release effort that the team is undertaking and I'm certainly proud of their efforts there.

[Rob Wertheimer, Melius Research LLC]

Perfect. Thanks, guys. Appreciate it.

[Operator]

Thank you. Ladies and gentlemen, we've reached the end of the question-and-answer session, and I will turn the call back to Mr. Dave Graziosi for closing remarks.

[David S. Graziosi, Allison Transmission Holdings, Inc.]

Thank you, Rob. Again, we'd like to thank everyone for joining us on the call this morning. We appreciate your interest and look forward to the next quarterly call. Have a good day.

[Operator]

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