Allison Transmission Holdings Inc

NYSE:ALSN

Earnings Call Transcript 2022-Q3

[Operator]

Good afternoon. Thank you for standing by. Welcome to Allison Transmission’s Third Quarter 2022 Earnings Conference Call. My name is Shamali, and I will be your conference call operator today. [Operator Instructions] After prepared remarks, Allison Transmission executives will conduct a question-and-answer session and conference call participants will be given instructions at that time. As a reminder, this conference call is being recorded. [Operator Instructions]

I would now like to turn the conference call over to Jackie Bolles, Executive Director of Treasury and Investor Relations, who has been recently appointed to the role. Please go ahead, Jackie.

[Jackie Bolles, Executive Director, Treasury and IR]

Thank you, Shamali. Good afternoon, and thank you for joining us for our third quarter 2022 earnings conference call. With me this afternoon are David Graziosi, our Chairman and Chief Executive Officer; and Fred Bohley, our Senior Vice President, Chief Financial Officer and Treasurer.

As a reminder, this conference call, webcast and this afternoon’s presentation are available on the Investor Relations section of allisontransmission.com. A replay of this call will be available through November 2.

As noted on Slide 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These forward-looking statements are subject to known and unknown risks including those set forth in our third quarter 2022 earnings press release, our annual report on Form 10-K for the year ended December 31, 2021, our quarterly report on Form 10-Q for the quarter ended March 31, 2022, geopolitical uncertainties and related responses by governments, customers and suppliers as well as other general economic factors. Should one or more of these risks or uncertainties materialize or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those that we express today.

In addition, as noted on Slide 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. You can find reconciliations of the non-GAAP financial measures to the most comparable GAAP measures attached as an appendix to the presentation and to our third quarter 2022 earnings press release.

Today’s call is set to end at 5:45 p.m. Eastern Time. In order to maximize participation opportunities on the call, we’ll take just one question from each analyst.

Please turn to Slide 4 of the presentation for the call agenda. During today’s call, Dave Graziosi will review highlights from our third quarter 2022 results and provide a brief operational update.

Fred Bohley will then review our third quarter financial performance and review updates to the 2022 guidance prior to commencing the Q&A. Now I’ll turn the call over to Dave Graziosi.

[David Graziosi, Chairman and CEO]

Thank you, Jackie. Good afternoon, and thank you for joining us. We are pleased to report our third quarter results, which reflect ongoing strength in our end markets and the continued focus of our team to drive results, though the operating environment continues to be challenging.

The resiliency of customer demand is demonstrated by a 25% year-over-year increase in revenue to $710 million for the third quarter. Notably, year-over-year net sales growth was surpassed by even stronger growth in diluted EPS, up 63% as Allison’s disciplined and well-defined approach to capital allocation continues to support per share returns in excess of net sales and net income growth.

Despite concerns of a slowdown in economic activity, customer demand remains robust with industry production limited primarily by persistent supply chain constraints. We anticipate that the current complex and uncertain operating environment will continue for the foreseeable future.

Though supply chains have not uniformly improved, end-user demand remains strong, and the Allison team continues to take actions that address and mitigate production challenges. As a result of the ongoing strength in Allison’s global on- and off-highway end markets we are pleased to raise the full year guidance while narrowing the guidance ranges provided to the market on August 3.

During the quarter, we announced changes to refresh our Board of Directors by adding 4 new members in early August with 4 current members serving out their term, but not standing for reelection at our 2023 annual meeting. The changes reflect a deliberate process by the Board to recruit new directors who will complement the overall mix of skills knowledge, experience and perspectives. We are pleased that we have identified 4 outstanding independent directors, who each bring extensive experience in areas relevant to our business and will be great assets to Allison.

In prior quarters, we emphasized programs that have gained traction and are driving revenue growth in our conventional business with a combined potential incremental growth opportunity $250 million in annual revenue.

In addition to the 3414 Regional Haul, FracTran and China widebody mining dump initiatives covered in previous quarters. Today, we will highlight new opportunities for our conventional products as well as provide an update on our electrified propulsion portfolio. As we recently announced, Allison has been named the exclusive provider of transmissions for XCMG’s all-terrain crane application as one of the top 3 largest construction machinery manufacturers in the world XCMG has already integrated the Allison 4970 Specialty transmission into dozens of its new all-terrain cranes and is seeing outstanding performance leading to continued growth in the Outside North America On-Highway market.

During the quarter, Isuzu unveiled their new medium-duty FVR truck in Taiwan that features the Allison 3000 Series 6 speed automatic transmission. The new Isuzu FVR truck was designed to tackle high stop-start duty-cycles and numerous application demands making the Allison 3000 Series to proven choice of propulsion to ensure fuel efficiency, enhanced maneuverability and increase the ability to move heavy loads in urban environments.

We are pleased to continue our outstanding partnership, and we are confident that the Isuzu and Allison combination will deliver superior economic value to fleets across Taiwan. Additionally, in our Outside North America On-Highway market, we continue to see growth opportunities in the agriculture sector since entering the market in 2015.

In South America, leading OEMs, including came in John Deere and Metalfor have chosen the Allison 2000 and 3000 Series transmissions for their agricultural sprayers as OEMs have made the transmission -- transition from manual transmissions, customers and drivers that operate ag sprayer, vehicles have benefited from integrating the Allison fully automatic transmissions due to enhanced performance in soft soil, which is critical in this application.

The agri business in South America continues to be an exciting growth opportunity for Allison, and we look forward to providing transmissions designed to meet the unique challenges of the industry. In September, Allison participating in the IAA Transportation Conference in Hanover, Germany, where we announced the latest addition to our eGen Power family, the 130S joining the eGen Power lineup of electric axles, which includes the 100D introduced in 2020, the 130D and 100S, both introduced in 2021.

The 130S includes new key components designed to specifically support the heavier 13-ton gross axle weight rating often required by commercial vehicles in the Europe and Asia Pacific markets. The introduction of the 130S is representative of Allison’s global approach to electric vehicle propulsion, and we are pleased to expand our eGen Power family of e-axles to deliver additional fully electric solutions for the European and Asia Pacific markets.

Also at the IAA Transportation Conference, we announced the eGen Power 130D e-axle was chosen as the propulsion solution for Quantron’s new fuel cell electric vehicle. The Quantron FCEV will utilize the 130D to support sustainability initiatives of customers and drive growth in our electrification portfolio. The implementation of the eGen Power family into fuel cell electric vehicles is a testament to Allison’s energy-agnostic, e-axle portfolio of propulsion solutions, which pair well with any source of energy.

Furthering our capabilities to support the development of alternative fuel vehicle solutions, we announced this quarter that our vehicle electrification and environmental test center is now capable of both testing and providing hydrogen supply for fuel cell vehicles. We are excited to expand the facilities capabilities to support our OEM customers as they develop and optimize alternative fuel offerings intended to reduce submissions.

During the quarter, we announced our strategic cooperation agreement with Anadolu Isuzu, Turkey’s leading bus and truck manufacturer. As part of the agreement, Allison’s eGen Power 100S will be incorporated into Anadolu Isuzu’s light-duty truck and midibus platforms for refuse, distribution and public transportation applications.

Allison’s conventional transmissions have been a preferred solution for their bus platforms for more than a decade, and we are excited to expand our offering and continue our long-standing relationship by delivering innovative solutions to our customers.

Early in the quarter, we announced the award of a $6.5 million contract from the U.S. Army’s Ground Vehicle Systems Center. This award will be used to support the design, development and testing of our newest addition to the eGen portfolio, the eGen Force. Allison has combined its decades of experience in both combat vehicles and electric hybrid propulsion solutions to develop the new eGen Force electric hybrid system, designed for 50-ton tracked vehicles, the eGen Force meets the requirements for the U.S. Army’s optionally manned fighting vehicle program and has been selected as the propulsion solution for American Rheinmetall Lynx vehicle. The eGen Force is also scalable to 70-ton tracked vehicles, making it capable of meeting future main battle tank requirements as well.

Finally, the eGen Flex, our zero-emission capable electric hybrid system that provides bus fleets with the optionality of full electric engine of propulsion for up to 50% of the duty cycle continues to gain share across transit properties in the United States. We recently announced that the Santa Clara Valley Transportation Authority has selected the eGen Flex propulsion system for its fleet of transit buses. This order represents the largest and most recent in a series of nationwide awards for buses equipped with Allison’s next-generation electric hybrid system.

As we have often said, there are more growth in technology initiatives happening at Allison today than at any other time in our history. We continue to invest across our portfolio to drive growth and deliver value propulsion solutions to all of our end markets. Thank you, and I’ll now turn the call over to Fred.

[Fred Bohley, SVP, CFO and Treasurer]

Thank you, Dave. Following Dave’s comments, I’ll discuss the Q3 2020 performance summary, key income statement line items and cash flow. I’ll then review updates to full year 2022 guidance. Please turn to Slide 5 of the presentation for the Q3 2022 performance summary.

Year-over-year net sales increased 25% to $710 million from the same period in 2021 driven by resilient customer demand, price increases and the continued execution of growth initiatives. The increase in year-over-year results was led by a 24% increase in the North American On-Highway end market, driven by continued strength in customer demand for last-mile delivery, regional haul and vocational trucks.

Year-over-year results were also improved by a 25% increase in the net sales in the service parts, support equipment and other end market, principally driven by global service parts and support equipment and aluminum die cast components, as well as a $26 million increase in net sales in the Global Off-Highway end markets, driven by demand for hydraulic fracturing applications in the energy sector as well as higher demand in the mining and construction sectors. And a 27% in net sales and record quarterly revenue in the Outside North America On-Highway end market, driven by the continued execution of growth initiatives in Europe, Asia and South America.

Gross profit for the quarter was $328 million, a 26% increase from $261 million for the same period in 2021. The increase was principally driven by increased net sales, and price increases on certain products, partially offset by higher direct material costs. Net income for the quarter was $139 million compared to $94 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by an unrealized loss on marketable securities and increased product initiatives and commercial activity spending.

Adjusted EBITDA for the quarter was $245 million compared to $189 million for the same period in 2021. The increase was principally driven by higher gross profit, partially offset by increased product initiatives and commercial activity spending.

Diluted earnings per share increased 63% to $1.45 from the same period in 2021, driven by higher net income and lower total shares outstanding.

A detailed overview of our net sales by end market can be found on Slide 6 of the presentation. Please turn to Slide 7 of the presentation for the Q3 2022 financial performance summary. Selling, general and administrative expenses increased $5 million from the same period in 2021, principally driven by higher commercial activity spending. Engineering research and development expenses increased $5 million from the same period in 2021, principally driven by increased product initiatives spending.

Please turn to Slide 8 of the presentation for the Q3 2022 cash flow performance summary. Adjusted free cash flow for the quarter was $182 million compared to $153 million for the same period in 2021. The increase was driven by lower capital expenditures and higher net cash provided by operating activities.

Consistent with Allison’s disciplined and well-defined approach to capital allocation, we repurchased $109 million of our common stock during the third quarter, representing 3% of outstanding shares.

We ended the quarter with a net leverage ratio of 2.5x, $180 million of cash and $645 million of available revolving credit facility commitments. In addition, we continue to maintain a flexible, long-dated and covenant-light debt structure with the earliest maturity due in 2026. Finally, we ended the quarter with approximately $1.1 billion of authorized share repurchase capacity.

Please turn to Slide 9 of the presentation for the 2022 guidance update. As Dave mentioned, given third quarter results and current end market conditions, we are pleased to raise the full year 2022 guidance while narrowing the guidance ranges released to the market on August 3. We expect net sales for 2022 to be in the range of $2.69 billion to $2.74 billion.

Our 2022 net sales guidance reflects higher customer demand in Global On-Highway, Global Off-Highway and service parts, support equipment and other end markets as well as price increases on certain products and the continued execution of our growth initiatives. In addition to Allison’s 2022 net sales guidance, we anticipate net income in the range of $490 million to $510 million, adjusted EBITDA in the range of $915 million to

$945 million, net cash provided by operating activities in the range of $620 million to $650 million, capital expenditures in the range of $160 million to $170 million and adjusted free cash flow in the range of $460 million to $480 million.

Thank you. This concludes our prepared remarks. Shamali, please open the call for questions.

[Operator]

[Operator Instructions] And our first question comes from the line of Ian Zaffino with Oppenheimer.

[Ian Zaffino, Oppenheimer]

Glad to see a lot of strength still continuing. Can we just like key in on pricing, can you maybe talk about the magnitude of some of your pricing you saw in the quarter? And maybe what areas? And what’s the outlook for fourth quarter and beyond from a pricing standpoint?

[Fred Bohley, SVP, CFO and Treasurer]

Ian, this is Fred. For the quarter, on a year-over-year basis, pricing was favorable $29 million. As we look at full year at this point, previously talked about 400 basis points of pricing. We have taken some pricing within the year and are now anticipating about 425 basis points of price.

So roughly $115 million in price on a year-over-year basis. As we talked about on previously earnings calls, as OEMs continue to raise the price of vehicles. And our transmission makes those vehicles more productive, more efficient from a fuel standpoint, they’re able to get more work done. It just increases the value of our transmissions. So we certainly feel well positioned to continue to capture price in this inflationary environment.

[Operator]

Our next question comes from the line of Tim Thein with Citi.

[Tim Thein, Citi]

Great. And welcome aboard to Jackie. Maybe Dave, just on the Global On-Highway, the strength you saw there, which presumably there’s some amount of currency headwind that would even flatter and even more when adjusting for that. But what do you attribute that? It’s not contract wins you would have gotten this quarter, obviously, but much of that is strength in maybe China? Well, China, I think, on-highway is actually worse in the quarter for the industry.

So what areas of the country or not in the country or the world that you highlight in terms of driving that strength, your continued strength rather? And what kind of -- visibility is always a challenge in the on-highway space, but what do you have -- are you looking forward to that specific market in ‘23? How do you kind of size that up?

[David Graziosi, Chairman and CEO]

You’re welcome, Tim. So let me just go around the world here quickly. So North America is, I’m sure you’ve read some of the public reporters that are out already with their comments. I don’t believe we would disagree with the general market conditions that are being described for North America, which is relatively strong.

You know all the attributes that are supporting the market right now in terms of significant backlogs because of the lack of production really dating back to 2020 into ‘21 at this stage. It certainly supports a relatively -- from our perspective, expectation for a pretty healthy market over the near to medium term.

It’s relatively broad for us, although, as you know, with our portfolio, we do have a fair bit of business in the vocational space that continues to be strong for us, and that’s prior to some of this infrastructure legislation that’s been passed to actually take hold, but I would say, overall, North America continues to be a pretty strong market.

Outside of North America, I think our team has done a very solid job supporting customers in a number of different markets at this stage. As you know, we’ve talked about the asymmetric reopenings that have occurred also some interim stops along the way in Asia that I’m sure you’re familiar with.

I think we’ve been extremely supportive of, as I’ve said, to try to keep both the end users certainly up and running, but also the OEMs to the extent that they have product and enough components to make vehicles. But I would say broadly there isn’t really a market out there that I would describe outside of North America that’s weak. I think all of them are relatively strong. It’s -- we’ll get to the 2023 guide. As you know, we always do with the fourth quarter call in the first quarter. So I won’t jump ahead of that at this stage, but I would say more broadly, our expectation is, again, subject to continued market conditions in terms of supply chain, which does have some challenges more broadly without a broader macro displacement at this stage that we do expect a decent tailwind heading into ‘23.

So beyond that, as we -- I referred to, in the prepared remarks, the supporting the growth initiatives that we have I think the team continues to do a very good job executing against those, and we’re pleased with the outcome. Specific to China, as you mentioned, they -- that market continues to be, for us, a combination of truck domestically in a number of areas, including mining, but on the export bus side as well. They’ve had a pretty decent year so far or so. Beyond that, I think, again, we’ll keep a close eye on things as we head into the end of the year, but the market is relatively strong overall.

[Operator]

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

[Jamie Cook, Credit Suisse]

Sorry. I guess just 2 questions. One, the strength in the parts and service business struck me this quarter, up 25%. So can you just -- and the drivers behind that? How much was market versus sort of pricing? And how sustainable is that level just given it’s probably accretive to your margins? And then my second question, Dave, is to you, just with the strength of the balance sheet and the cash flow and valuations coming in across the market, if you could just update us on what you’re seeing in terms of M&A opportunities? And is there opportunities for Allison to be more acquisitive relative to history?

[Fred Bohley, SVP, CFO and Treasurer]

Jamie, this is Fred. Relative to the strength on the service parts, support equipment and other was primarily driven by the service parts, but we also had, obviously, a strong unit volume. So the support equipment used to support the initial installation was up. And we were also up with aluminum die cast components. So it was pretty broad-based. It was definitely a strong quarter. You continue to see, obviously, trucks running longer more repairs needed. Obviously, some challenges within the channel from a labor standpoint to get all that done. But definitely a strong quarter. Candidly, a little stronger than we had anticipated when we forecasted things.

[David Graziosi, Chairman and CEO]

Jamie, it’s Dave. So on your balance sheet or cap allocation question, I guess, directly or indirectly relative to M&A opportunities, we continue to stay very close to the market and a number of our contracts. I think our business, as you know, you followed us for a number of years, continues to become broader in terms of a number of activities that were involved and beyond transmissions.

Allison is more than a transmission company we are thinking of ourselves and the market more broadly in that context. So I would certainly point to -- we believe there’s a number of opportunities for the team here to add value for our shareholders. Having said that, we are a patient bunch and very disciplined. So we do expect there will be opportunities at the same time at appropriate valuations, as you would of us. I also think more broadly about as we -- this point in the cycle with the market where it is, the market is more broadly busy in terms of our core markets.

So that being said, I do think there will be a number of opportunities, whether those are near term or not remains to be seen, just given the broader market conditions. What I mean by that is, as best I can tell, everybody is relatively busy. So given that as a backdrop, plus I think some of the challenges more broadly in the financial markets, as you’re well familiar with, it’s something we continue to be very focused on, but very patient and disciplined about how we’re thinking about opportunities.

[Operator]

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

[Rob Wertheimer, Melius Research]

I wanted to ask about two things, I guess, on the, I guess, the advanced powertrain side. One is, I don’t know if you have an update on eGen Flex and just the hybrid transmission and whether that’s kind of a I don’t know whether that’s a growing market or a legacy market where fleets have adopted it, continue to replace and expand with it or if it’s real growth. And then just more generally I’d love it if you could just give us an update. You’ve been very active across advanced powertrain on the state of the market, whether customers are buying for efficiency, where you see your market positioning, where you see your win rates and the things that you want to win, just the general state of development.

[David Graziosi, Chairman and CEO]

You for the questions, Rob, it’s Dave. So just on the eGen Flex, I understand the legacy of that product dates back about 20 years. I mean it was very unique at that point. I think there’s over 9,000 of those systems running globally at this point. The eGen Flex was really the next generation of that we used to refer to or what is known in the market as the H4050. The big difference with the eGen Flex is that we added full EV capability up to 10 miles and a number of attributes around 50% in EV mode on a duty cycle up to -- et cetera.

So I would say, certainly a much more advanced. But product and solution, I also think it’s very responsive to [indiscernible] the customer around zero emission zones. So the long of all that is, as you think about that, it’s really a successor product with a number of improvements that are responsive to the marketplace. So it’s more of the future, if you will, but really dealing with legacy marketing position, if you want to think about it that way.

In terms of your question on the broader advanced powertrain space and a number of opportunities that we’re looking at. We continue to receive a fairly high level of interest in our eGen Power lineup of e-axles. I was -- mentioned in the prepared remarks, I -- Hanover, I think our team showed very well at the show itself. We had a tremendous amount of traffic in and out of our booth there, a number of, I think, very good quality meetings, a lot of attention paid to our products, especially our solutions when they are compared to a number of other parties in the marketplace.

So I also mentioned in the prepared remarks, the Quantron effort, we’re being relatively focused and selective about who we’re choosing to work with at this point. The gist of all that is that it’s really focused on being power agnostic, but thinking about our focused efforts around the Allison brand promise and solutions that, frankly, are consistent with our products, which, as you know, are -- have a reputation for being extremely high quality and reliable.

And we believe anything we’re going to field in terms of alternative powertrains, advanced powertrains are going to meet or exceed the conventional standard that we’ve created. So that’s really the focus of any engagements we’re having at this point. So I think we’re very pleased with the team’s reception in the marketplace and the progress we’re making.

And again, I think we continue to also leverage the investments that have been made over the last few years through acquisitions, talent that we brought on since then, but also the facilities we’ve now added, whether that be our team in Auburn Hills, and also the vehicle electrification and environmental test center here in Indianapolis, which are very -- it’s a very unique facility, but it’s also given us the ability to partner in an accelerated way to a number of parties.

So I think the overall summary is pleased with where we are. We see a lot of opportunity there. But I would also note, it’s still relatively early days for some of those powertrain solutions in general. And we’re prepared to be patient and do things the right way, consistent with our brand promise.

[Operator]

Our next question comes from the line of Felix Boeschen with Raymond James.

[Felix Boeschen, Raymond James]

I’m curious about some of the opportunities from a revenue perspective. You’ve called out the regional haul, the dump body initiative in China and the FracTran. I think it’s about a $250 million revenue opportunity all in. Just kind of curious if you can maybe give us an update on those 3 launches, what may or may not already be in the numbers versus what’s sort of slated to come online in coming years would be super helpful.

[Fred Bohley, SVP, CFO and Treasurer]

Sure, Felix. This is Fred. The -- as you can imagine, they’re all 3 at different stages. The regional haul has been out there for a couple of years. We’ve achieved releases with Navistar, Daimler, Volvo. Certainly, what’s notable there is a couple VI OEMs. The widebody mining dump in China, we’ve seen some fairly fast adoption there. And then you go to the FracTran, which is really still early stages from a launch standpoint. So the $100 million opportunity from FracTran, there’s really no revenue within the run rates.

The widebody mining dump, it will be interesting to see how we finished the year. We targeted that at $50 million. There’s been really quick adoption. I think we’ll probably be halfway there. And we may have undershot what potential opportunities there is. So we continue to look at that.

Regional haul is we’ve got a lot of the key releases. We’ve got customers that have tried 5, 10 units, which is pretty normal in the conventional market, especially in North America, conservative end users that are coming back for the second, third purchase. But as far as where do we stand versus that $100 million, probably 10% there. So a lot of this is still in front of us. And then as Dave talked about in the prepared remarks, there is a lot of activity that’s ongoing. I mean, record Outside North America On-Highway, Defense business, we’ve made a significant amount of investments there.

And some of those programs are coming to fruition with the M88, the MPF. Obviously, the -- in the conflict in Ukraine driving the Western European OEMs to rebuild their fleets that a lot of us has been put in the theater there in Ukraine. And just in general, anybody historically that’s been used in Russian equipment is, in a lot of cases, looking for other sources.

So quite a bit of opportunities. We’re very pleased with the pace we’re on with those 3, but we’re not done. There’s a significant amount of opportunity to continue to drive this conventional business forward.

[Operator]

Our next question comes from the line of Tami Zakaria with JPMorgan.

[Tami Zakaria, JPMorgan]

So my first question is, how should we think about your gross margin rate in the fourth quarter? Because it seems like gross margin rate erosion has finally inflected, and you had leverage in the third quarter after several quarters. So any thoughts on how you’re thinking about gross margin in the fourth quarter? And then also next year, maybe given some of the commodity prices are coming down.

[Fred Bohley, SVP, CFO and Treasurer]

Tami, this is Fred. Really, as we look at the fourth quarter, and I’m sure you’ve probably done the math on kind of the implied guide into the fourth quarter. Traditionally, fourth quarter is one of the softest quarter just because of the fewer number of production days with the holidays. And as we look at it, that is how we anticipated this year. We do -- we’ve started to see some commodity prices roll off. So certainly expect to be price/cost favorable in the fourth quarter. As relative to 2023, we’re doing a significant amount of work around 2023. We definitely anticipate getting price but continue to model the top line and the cost structure, and we’ll provide commentary on that when we put out our Q4 results in February with that initial 2023 guide.

[Tami Zakaria, JPMorgan]

Got it. That’s helpful. If I can squeeze in one quick one. How should we think about the Defense business? When do you expect that to start growing again year-over-year?

[David Graziosi, Chairman and CEO]

Tami, it’s Dave. So to Fred’s comments, a number of programs that we’re working on. New programs and some -- both for the -- through the U.S. government as well as outside North America. I think the answer to your question is in the next really year or 2, you should start to see Defense increase. I would say, once you get out within 2 years, call it, subject to the programs actually being funded and occurring on time, which is -- I’m specifically referring to tracked programs, it’s a pretty meaningful ramp versus history back 10-plus years ago, with the activities in the Middle East, it was largely -- if you look at our Defense business, largely wheeled in terms of volume.

The team has spent the last 4 to 5 years, working very aggressively on growing both our U.S. presence as well as outside North America to Fred’s point, the unfortunate situation with the Ukraine has created, frankly, a new market space for Allison. So the team is also engaged on -- in that process as well, but we’re certainly looking forward to significant growth from our Defense portfolio at this stage.

[Tami Zakaria, JPMorgan]

Got it. And great quarter, congrats on that.

[Operator]

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

[Jerry Revich, Goldman Sachs]

I’m wondering if you can just talk about the fourth quarter sales outlook at the midpoint of the range, I think you’d be down mid-single digits sequentially, which is worse than seasonality we’ve seen over a number of years. I’m wondering, is that just a function of allowing the supply chain room to execute? Or are there any end markets specifically where you’re expecting lower deliveries?

And similar question on margins. So the midpoint implies margins are down 200 basis points sequentially. And I’m wondering if you can talk about are there discrete items driving that? Or is that again, just to provide room to execute given the supply environment.

[Fred Bohley, SVP, CFO and Treasurer]

Jerry, this is Fred. Yes. I think one thing and important to look at is, certainly, we did increase guide both from a revenue earnings and cash, but as specifically as we look at Q4, we have revenue much closer to Q2. Q3 for us, $710 million, one of our strongest revenue quarters in history.

We do have Q4 down, which is I would say, is normal seasonality, although last year was really unusual with Q4 being our strongest revenue quarter. Specifically, when you get -- looking at the various end markets I wouldn’t say anything necessarily stands out. Parts of support equipment and other was really strong in Q3, and we don’t anticipate repeating at that level. We do expect North America Off-Highway to be down quarter-over-quarter. And then really, back to your question on margins, it’s primarily just a function of the reduced revenue and associated drop-throughs impact in Q4. And as I mentioned, it’s very common for Q4 to be lowest margin quarter for us of the year.

[Jerry Revich, Goldman Sachs]

And sorry, Fred, just a clarification there. What part of the part of support equipment is with the off-highway piece, the die cast piece? Just a little more context on where you’re anticipating that?

[Fred Bohley, SVP, CFO and Treasurer]

I think we have a lot of strength in global on- and off-highway. So it was really an outlier quarter, Jerry. So that’s the portion that we’re not anticipating recurring in Q4.

[Jerry Revich, Goldman Sachs]

Super. Nice quarter.

[Operator]

And our next question comes from the line of Sherif El-Sabbahy with Bank of America.

[Sherif El-Sabbahy, Bank of America]

Just wanted to discuss gross margins a bit more broadly. Could you walk us through some of the changes over the past few years that have impacted gross margin and sort of break them out by what’s more cyclical or structural? And then within those moving pieces, what do you see coming back that could drive margin to return to more historical levels?

[Fred Bohley, SVP, CFO and Treasurer]

Sherif, this is Fred again. It really depends on how far you go back. I mean the biggest challenge with margins have been the significant cost increases, which primarily began with raw material. And what we’ve -- we talked about on previous calls, if you would see raw material returning to sort of pre-pandemic levels, that should provide about a 200 to 225 basis point lift to our gross margins.

And we do have -- on those commodities, we have pass-through methodologies with -- within a lot of our long-term supply agreements, but we don’t pass through 100%. And then we don’t have the entire book of business on long-term supply agreement. So as raw materials have increased, we’ve only passed through about 60% via our surcharge methodology.

And that’s traditionally lagged 6 to 12 months. So you are starting to see commodities roll. In the short term, we don’t have to pass those on. And then ultimately, when we do, it will be $0.60 on a dollar. That’s been the biggest impact.

The second thing would just be just general operational inefficiencies that’s occurring with the challenges in the supply chain, the challenges of our customers to build what they want to build. It creates inefficiencies for both our suppliers and for our manufacturing facilities. So I think as you move through and get more strength within that supply chain. Those are costs that I think we all look forward to removing.

[Operator]

And we have reached the end of the question-and-answer session. I will now turn the call back over to David Graziosi for closing remarks.

[David Graziosi, Chairman and CEO]

Thank you, Shamali, and I thank all of the call participants for your continued interest in Allison and for participating on today’s call. Enjoy your evening.

[Operator]

This concludes today’s remarks. If you have any -- you may disconnect your lines at this time. Thank you for your participation.