Allison Transmission Holdings, Inc. (ALSN) Q3 2012 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to Allison Transmission's Third Quarter 2012 Earnings Conference Call. My name is Nancy, and I will be your conference operator for today. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference call over to Mr. Dave Graziosi, the company's Executive Vice President and Chief Financial Officer. Please go ahead, sir.

Thank you, operator. Good afternoon, and thank you for joining us for our third quarter 2012 results conference call. With me this afternoon is Larry Dewey, Allison's Chairman, President and Chief Executive Officer. As a reminder this conference call, webcast and the presentation we are using this afternoon are available on the Investor Relations section of our website, allisontransmission.com. A replay of this call will be available through November 5. As shown on Page 2 of the presentation, many of our remarks today contain forward-looking statements based on current expectations. These statements may often be identified with words such as expect, anticipate, believe or similar indications of future expectations. Although we believe that such forward-looking statements are reasonable, we cannot assure you that any forward-looking statements will prove to be correct. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors as well as general economic conditions. Should one or more of these risks or uncertainties materialize or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those that we express today. Additionally, let me refer to you to our third quarter 2012 results press release and our March 15, 2012, prospectus, which was filed with the SEC where you will find factors that cause actual results to differ materially from those forward-looking statements. In addition, on Page 3 of the presentation, some of our remarks today contain non-GAAP financial measures as defined by the SEC. The presentation of this additional information is not meant to be considered in isolation or as a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP and should not be considered as an alternative to the GAAP measures. 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 2012 results press release, both of which are posted on the Investor Relations section of our website. Today's call is set to end at 5:30 Eastern time. [Operator Instructions] Now I'll turn the call over to Larry Dewey.

Thank you, Dave. Good afternoon, and thanks, everyone, for joining us today, particularly those of you on the East Coast. Hopefully, you're battened down pretty well for the weather that's coming at you. Despite a year-over-year decline in third quarter net sales largely attributable to the previously considered cyclicality of the North America Energy sector's hydraulic fracturing markets, diminished North America On-Highway commercial vehicle production schedules and reduced U.S. defense spending, Allison continued to demonstrate strong operating margins and cash flow while investing in growth opportunities. During the third quarter, we also maintained our commitment to prudent capital structure management by refinancing approximately half, or $850 million, of Allison's senior secured Credit Facility Term B-1 loan due in 2014, repaid $105 million of debt and paid a quarterly dividend to our shareholders. Consistent with our previous 2012 guidance, we expect no meaningful relief from the third quarter North America end markets' challenges in the fourth quarter, typically Allison's slowest quarter due to seasonal production downtime taken by many of our customers. Please turn to Slide 4 of the presentation for the call agenda. On today's call, I'll provide you with an overview of our third quarter 2012 performance, including sales by end market. Dave will review the third quarter 2012 financial performance, including adjusted EBITDA and free cash flow. I'll then provide an overview of our end markets and wrap up the prepared comments with updated full year 2012 guidance prior to question and answers. Please turn to Slide 5 of the presentation for the Q3 performance summary. Net sales decreased approximately 14% from the same period in 2011, principally driven by decreased demand for North America Off-Highway products relative to the elevated demand we were experiencing in the prior year period driven by the strength in natural gas pricing. The North America On-Highway, Military and Service Parts, Support Equipment & Other end markets also experienced modest declines, which were partially offset by price increases on certain products. Our Outside North America net sales were in line with the prior year due to growth in China, offsetting weakness in European end markets. Gross margin increased 60 basis points from the same period in 2011, principally driven by improved manufacturing performance, favorable material costs and price increases on certain products. Adjusted net income decreased $31 million from the same period in 2011, principally driven by decreased gross profit, $12 million of certain technology-related license expenses and increased cash interest expense as a result of debt refinancing and repayments, partially offset by lower global commercial and engineering research and development spending activities. Adjusted free cash flow decreased $56 million from the same period in 2011, principally driven by decreased net cash provided by operating activities and increased capital expenditures attributable to increased product initiative spending and investments in productivity and replacement programs. Consistent with our previous 2012 guidance, we completed the expansion of our India facility during the third quarter. Please turn to Slide 6 of the presentation for the Q3 sales performance summary. North America On-Highway end market net sales were down 5% from the same period in 2011, below expectations due to increased deterioration in commercial vehicle production. During the third quarter, we experienced lower demand for Rugged Duty Series and Highway Series models. These reductions were partially offset by increased sales of Pupil Transportation and Shuttle Series as well as the Motorhome Series models. North America Hybrid-Propulsion Systems for Transit Bus end market net sales were up 7% from the same period in 2011, principally due to the timing of orders. As we noted during our second quarter conference call, second quarter 2012 net sales were down 55% from the same period in 2011 principally due to inter-year movements in the timing of orders. North America Off-Highway end market net sales were down 71% from the same period in 2011, principally driven by lower demand from hydraulic fracturing operations due to weakness in natural gas pricing. Third-quarter net sales were also below expectations due to further deterioration in hydraulic fracturing rig production and utilization rates despite some improvement in natural gas pricing. Military net sales were down 9% from the same period in 2011 principally due to lower wheeled and tracked products requirements, consistent with reduced U.S. defense spending. Outside North America On-Highway end market net sales were flat with the same period in 2011, reflecting strength in China being offset by weaker environments in Europe and Latin America. Outside North America Off-Highway end market net sales were down 8% from the same period in 2011, principally driven by weaker Mining sector demand, partially offset by stronger demand from the Energy sector. Service parts, support equipment and other end market net sales were down 10% from the same period in 2011, principally driven by lower demand for global Off-Highway service parts and reduced support equipment sales commensurate with decreased transmission unit volumes. Now I'll turn the call over to Dave Graziosi.

Thank you, Larry. Please turn to Slide 7 of the presentation for the Q3 financial performance summary. Given Larry's comments, I'll focus on other income statement line items and adjusted EBITDA. Selling, general and administrative expenses decreased $5 million, or 5%, from the same period in 2011. The decrease was principally driven by lower global spending activities, partially offset by the elimination of favorable 2011 product warranty expense adjustments. Engineering, research and development expenses increased $4 million, or 12%, compared to the same period in 2011 principally due to $12 million of certain technology-related license expenses from the execution of a co-development agreement with Fallbrook Technologies and a partial contingent license exclusivity payment to Torotrak, partially offset by the timing of product initiative spending. Interest expense, net, decreased $23 million or 36% from the same period in 2011, principally driven by an $18 million decrease in mark-to-market expense for our interest rate derivatives, $13 million of lower interest expense as a result of debt repayments and purchases, partially offset by higher interest rates and amortization of deferred financing fees related to refinancing of our senior secured credit facility and the effectiveness of new interest rate swaps at higher interest rates. Other expense, net, decreased $2 million from the same period in 2011, principally driven by favorable foreign exchange, higher gains on derivative contracts and a decrease in premiums and expenses related to redemptions of long-term debt, partially offset by the impairment of technology-related investments and decreased grant program income. Income tax expense for the quarter was $17 million, resulting in an effective tax rate of 34.6% versus an effective tax rate of 32% for the same period in 2011. The effective tax rate increase was principally driven by higher discrete activities in the same period in 2011. Adjusted EBITDA, excluding technology-related license expenses, for the quarter was $172 million, or 34.8% of net sales, compared to $193 million, or 33.7% of net sales, for the same period in 2011. The decrease in adjusted EBITDA was principally driven by a decreased gross profit, partially offset by lower global and -- commercial and engineering research and development spending activities. Increase in adjusted EBITDA margin, excluding technology-related license expenses of approximately 110 basis points, was principally driven by the previously referenced gross margin improvement and lower global and -- lower global commercial and engineering research and development spending activities. Please turn to Slide 8 of the presentation for the Q3 cash flow performance summary. Given Larry's comments, I'll focus on specific cash flow activity during the third quarter and provide some fourth quarter 2012 guidance. Allison continued to demonstrate a solid, reoccurring free cash flow conversion rate during the third quarter despite weakening sales demand, inconsistent commercial vehicle production schedules and labor negotiations planning. As Larry mentioned, we refinanced a $850 million of our 2014 senior secured Credit Facility Term B-1 loan during the third quarter. Early this month, we refinanced an additional $300 million of the Term B-1 loan, resulting in a remaining August 2012/2014 maturity of $500 million. These latest refinancing activities, together with other refinancing transactions completed in 2011 and the first quarter of 2012, have better aligned Allison's debt maturities with this over-the-cycle free cash flow and longer-term net leverage targets. During the quarter, we also repaid $105 million of debt and paid a dividend of $0.06 per common share. Allison ended the quarter with $82 million of cash, $372 million of revolver availability after letters of credit and net leverage of 3.89. Looking forward to the fourth quarter, we plan to pay our quarterly dividend of $0.06 per common share. We will announce the record date and payment date of the dividend by press release once determined. Now I'll turn the call over to Larry Dewey.

Thank you, Dave. Please turn to Slide 9 of the presentation for the end markets commentary. Consistent with our second quarter conference call, full year net sales guidance were, consistent with our second quarter conference call, we're maintaining a cautious approach to the full year net sales guidance given heightened global economic uncertainties. Accordingly, I would highlight the following for our end markets. North America On-Highway, we expect full year net sales growth of 8%, implying a year-over-year reduction in the fourth quarter. We attribute the fourth quarter weakness to the stalled market recovery driven by heightened uncertainty and diminished commercial vehicle production forecasts. North America Hybrid-Propulsion Systems for Transit Bus. We expect a full year net sales reduction of 16%, implying a year-over-year growth in the fourth quarter. We attribute the fourth quarter strength to the timing of orders given no improvement in this sector of municipal spending. North America Off-Highway. We expect a full year net sales reduction of 43%, implying a year-over-year reduction in the fourth quarter. We anticipate no meaningful relief from the North America Energy sector hydraulic fracturing markets' challenges given forecasts for a continued softness in rig utilization rates attributable to weakness in natural gas pricing and increased levels of surplus or underutilized equipment. Military. We expect a full year net sales reduction of 2%, implying a year-over-year reduction in the fourth quarter principally driven by reductions in U.S. defense spending. Outside North America On-Highway. We expect full year net sales growth of 1.5%, implying a year-over-year reduction in the fourth quarter. We attribute the fourth quarter weakness to heightened economic uncertainties, diminished commercial vehicle production forecasts and continued softness in the European end markets. Outside North America Off-Highway. We expect full year net sales growth of 27%, implying year-over-year growth in the fourth quarter. We anticipate fourth quarter demand will reflect the sector trends we experienced in the third quarter. Service Parts, Support Equipment & Other. We expect a full year net sales reduction of 1%, implying a year-over-year reduction in the fourth quarter, principally driven by lower demand for global Off-Highway service parts and reduced support equipment sales commensurate with decreased transmission unit volumes. Please turn to Slide 10 of the presentation for the full year 2012 guidance update. Allison expects 2012 net sales to decline in the range of 2.5% to 3.5%; an adjusted EBITDA margin, excluding technology-related license expenses, in the range of 33.5% to 34%; and an adjusted free cash flow in the range of $350 million to $380 million or $1.88 to $2.04 per diluted share. Capital expenditures are expected to be in the range of $120 million to $130 million, which includes maintenance spending of approximately $62 million and are subject to timely completion of development and sourcing milestones for new product programs. Cash income taxes are expected to be in the range of $12 million to $15 million. This concludes our prepared remarks. Nancy, please open the call for questions.

[Operator Instructions] And we'll go first to Ann Duignan from JPMorgan.

I wanted to start out with your gross margin. It was pretty impressive given the sales decline. And Larry, maybe you could just tell us a little bit more about what specifically you have done in the manufacturing environment and where you've been able to make cuts that allowed you to keep the gross margins as high as they were?

I think probably 3 things that came into play. One was certainly, we've seen some relief on materials. And in the manufacturing arena, we continued to press on improving the efficiencies. One of the measures we speak to quite frequently is hours per unit, and the guys have continued to do a nice job there, some of which is tied to that, what we call our sustainment capital, where we'll get equipment that allows us to capture some additional labor productivity as well as just driving out some of the I'll call it operational work paths, i.e. industrial engineering-type efficiencies. And then the final thing, I think year-over-year there was a net change in the warranty cost I believe Dave referenced in his comments.

Okay. And then on the material costs, the lower material costs, will you be required to give those back or partially give those back to your OEM customers going forward?

We do have the supply agreements, as you should point out, and we've established the -- we established baselines for each of those relative to our material costs. So it would really depend on which baseline that we established, what the time frame of that was and then how the current ones, while lower than what they spiked to, how those play out. I believe, as it stands now on balance, we're still above the baseline. So I guess I'd look to Dave here for any...

Yes, we should -- I would say going forward, certainly for next year, we wouldn't expect a significant change in terms of the give back, if you will, pass-through.

Okay. So we -- these gross margins, you think, despite revenue headwinds should be sustainable. Is that the message we should take away?

We've talked several times before in terms of sustainability with the various programs, and Larry obviously alluded to a few. We also have the continuing dynamics of the demographics and the hourly side in terms of retirement eligible, et cetera. So those issues combined certainly will help. That being said, I think, as you know, following the sector as closely as you do, there's certainly going to be some challenges out there in terms of supply chain going forward just given the relative tightness in certain regards. So I think as you balance all that out, we feel good about where we are from a margin standpoint.

Okay. And then just a quick follow-up. As we head to the end of the year and into 2013, which of the end markets are you most concerned about as it stands today with the limited visibility that you have? But which one do you -- are you concerned most?

I'm a full-time ponderer. So when we -- you look at the Military, that's moving in the direction that we talked it was. North America On-Highway, the question is when are we going to get back on track for a more stronger type recovery. Obviously, we're seeing some recovery, but it's not at the level people thought. Now the issue is when are we going to get back on track with that. The Energy sector continues to be challenged in the frac-ing areas, especially in the natural gas sector. You're seeing people into the liquids. But as we've indicated, that's not as equipment-intensive as the gas and the shale plays. So we'll watch that. I think you're seeing some improvement in the pricing, and you're certainly seeing a lot of that activity that will drive fundamental baseline demand, whether it's vehicles, whether it's power plants, whether it's the dozen-or-so applications to export LNG. As some of those process presumably are improved. That's going to change some of the dynamics. I read something recently that said that could add as much as 20% to the demand here in North America, and we are seeing the growth for our equipment outside of North America, as we indicated in the Energy sector. So non-NAFTA, you got the European situation, but we're making some nice gains in terms of their releases. We feel we're solidly positioned there as those markets continue to develop. So I would say if you had to pick 2, I'd say we're watching the Energy sector here in North America very closely and also the commercial On-Highway business.

The next question comes from Jerry Revich with Goldman Sachs.

Dave, Larry, can you talk about the levers that you're exercising to rightsize the cost structure from here? Your fourth quarter outlook is for roughly a 10% cut in production. And judging by the OEMs, that type of environment is going to continue through call it first half of '13. So I'm just wondering if you could just step us through any changes you're making to the cost structure relative to the third quarter production rates.

Well, yes, there's a lot of uncertainty in terms of -- and you're right, there are -- folks certainly aren't sounding a lot of optimism. Although in fairness, we have had some movement in both directions here with some of the schedules, some cuts. And now people are looking to say, "Okay, nobody really knows, and we're trying to sort through that." We're certainly watching to make sure that, number one, we're not tying up a lot of cash in inventory. We're -- certainly, we did not add hedges, as I indicated in previous calls,. When we saw what appeared to be some schedule increases, we actually, in our plans, laid in overtime days. So as a result, as the volumes haven't necessarily materialized in some of the On-Highway sectors to the level we thought, we have been able to eliminate overtime days, and we don't have an overhang of staffing, which has been helpful. We are probably depending on some of the OEMs' plans. We're going to look at how we balance our rates. Do we change the line rate? Or do we take intermittent downtime? Those are, I think, tools that we've used historically. So we feel pretty comfortable with that. Obviously, on the purchase side, while the volumes aren't recovering as fast as what everybody thought, they are still up. And subject to the purchase agreements we have, we think we're pretty solid there. So those are some of the things that we're doing to make sure that we've avoided creating overhangs and making sure that we watch our expenses. And we have a culture here. We see how things are playing out. We have a lot of initiatives, and we are very clear about prioritizing those. We talk about it like a family budget. You have ideas of what you'd like to do. And depending on how the income comes in, then you adjust those projects you tackle based on what's going into the bank account.

So it sounds like you still have room from an overtime standpoint to cut the hours per person relative to the 10% top line cut you're looking for, for the fourth quarter?

Yes, we think we've certainly taken the overtime days out, and now we're looking at how we think the inventory is going to play out versus potential -- we could take some days out of the schedule with some scheduled downtime. We've done that -- we've already done a little of that this year, and we may do some more of that in the fourth quarter.

And then thinking about the R&D and SG&A outlook for the next 12 to 18 months, can you just step us through your framework where you are in the major projects? And can we see some scale-down in R&D in a few months? Just touch on how we should be thinking about pricing net of material costs and the new model year trucks for North America On-Highway.

Sure, the -- it's Dave. A couple of things. In terms of the run rate on the engineering and research and development, as we've talked before, the TC10 Metro transmission product as well as the H3000, those programs are starting to come to a bit of an end in terms of the development efforts. So that will move into 2013. Certainly, post 2013, we will look to start scaling back a bit at that stage. As Larry and I had mentioned before, certainly the concept of backfilling the new product development pipeline is certainly something we're focused on. At this stage, we don't have necessarily something to fill in come 2014. But as we look beyond that into the '15, '16 time frame, that's something we'll put some more energy into in terms of scheduling. That being said, as you think about the products, both the TC10 and H3000, as we talked before, we expect those products both to have relatively slow ramps, as consistent with the past in terms of commercial vehicle sectors. So I would not spend a tremendous amount of time focused on those in terms of run rates for '13 at this stage. We're still formalizing our launch timing there and working with various OEMs on those programs. So we'll leave that to be announced next year when those plans are firmed up.

We'll take the next question from Andy Kaplowitz with Barclays.

Larry, can you talk about your success, I mean, kind of trading the emerging markets, really China, as you've highlighted, in the non-North American On-Highway market? I mean, it's been a source of strength for you guys. You've been able to offset Europe. How much is China now of that business? And is that sort of success you've had sustainable going forward?

I'm going to let Dave speak to the percentages there, but let me just talk about the methodology. We established ourselves -- well, actually, we've been there in a limited way in the Off-Highway sector. However, as China has gotten more involved -- and I think they just finished up a bid for a lot of areas to be developed for Energy -- a number of the -- in fact, I think, in every case, a state-owned company won the bid there recently. But nonetheless, they've certainly gotten more aggressive. And as they've done that, our leadership position, we'd like to say, in the Energy sector, for the transmissions in that sector, is recognized. And as a result, we have been gaining a lot of business through the Chinese OEMs in the Off-Highway Energy sector. We're also starting to get more business in the Mining sector, although we have been there through Terex [indiscernible] for a number of years, decades. And now some of the other companies, [indiscernible], et cetera, have been starting to release the Allisons. In the On-Highway space, the bus activity continues to be strong, it's a competitive business with Voith and ZF certainly trying to claw their way into that market. We feel good about the position we have, and we're going to continue to work to earn a very good portion of that business. And then we're branching out beyond the On-Highway space into the truck sectors. We've got some business in fire trucks. That's come a little slower. We've got good releases there, but the volumes have been a little slower. But we're broadening those releases into construction and other emergency vehicles. So China has been a good story for us. It's been strong this year. And we feel good about Europe other than the fact that we feel good about our release activity, let me put it that way. The market itself is very soft, but we continue to gain releases. We continue to position ourselves well. And when that market does come back, we think the window will catch the sails that we've put in place there as well.

Jerry, it's David. In terms of the -- our China business, I figure, based on our guidance here, it's roughly about 8% of our consolidated sales out of the China business. Larry mentioned in terms of releases and then our standard investor relations presentation but truck releases we very much focus on, as you know, given typically the entry point with bus. But as of the end of last year, we had about 72 truck releases. We're certainly expecting this year at least a 25% growth in terms of truck releases by the end of the year. So again, a lot of the inroads that Larry mentioned, and those efforts continue to accrue to Allison's benefit. And we'll continue to pursue the balance of projects that we have out there.

Okay. That's helpful, guys. Larry, if I could follow up on that non-American Off-Highway market. You do model actually a slight sequential improvement in the fourth quarter, and we're all well aware of the pressure that's on Mining CapEx globally. So could you reconcile that? Is that just sort of you're gaining share in China? Is that sort of what you're counting on as you go forward?

Well, there's some activity there. Frankly, there's some activity in Russia that we've got going on that we haven't had historically. And there's -- we're starting to see more activity out in Latin America as well. So all of those end markets. I -- we certainly do see folks looking at what that sector -- yes, it's a mixed bag. I would say we've gotten some reductions from a couple of our OEMs. But with the new OEMs we've added, net-net, we're forecasting where we've indicated.

[Operator Instructions] We'll move next to David Leiker with Baird.

This is John [ph] on the line for David. If I did the math right, looking at what you're expecting for your Q4 North America On-Highway business, it looks like about a 15% sequential decline. I'm wondering, can you bucket that between what the industry is expected to do versus one of your larger customers starting to have share gains in their medium-duty product line? Share losses, excuse me.

Well, the -- yes, we don't talk individual OEMs. But certainly, the numbers that we had for the top OEMs is available from our public reporting. I would tell you the -- potentially the one that you're referring to, that volume is down slightly this year. But it's been certainly absorbed by other OEMs, to your point. As we think about our guidance versus the broader market, I would just say, without being -- getting into specifics, we prepared it from a bottoms-up approach with OEM input as well as barriers forecasting sources, as we talked about. So without endorsing any of those, I would certainly say that we believe our approach is prudent. I would also call your attention to the fact that as we recall, not many had accurately forecast the Q3 results in terms of production days and schedules. So with that in mind, we certainly took that into account in Q4. And I would tell you more or less the mix is consistent with our full year book of business at this point.

So the main takeaway there, if I can maybe summarize, is that customers might move away from OEM A, but you're still capturing their transmission business?

I think that's a fair assessment.

Okay, great. And then if I look at the North America Energy business or Off-Highway business, it looks like, based on full year expectations, that business is seen at flat sequentially. The other big transmission player in the market was talking about a pickup in call it Q2 of 2013. Do you think we're in a position here where volumes are pretty much flat for the next several quarters? And is that timing, so like a summer 2013 tick up, kind of in line with your expectations on when your volumes could start to inflect in that business?

Well, we -- I think we've overall had certainly read some of the same guidance you're referring to. I would say there's differences amongst component suppliers given order cancellation timing, et cetera. That being said, we have certainly availed ourselves as much as possible to inventory numbers in the field as well as rate counts and utilization rates that Larry referenced and, given all of that input, again did a bottoms-up approach for our Q4. At this stage, we're not providing 2013 guidance and are watching closely as well as you are all of the data points that are out there. But I think the fact remains is that based on industry input, with natural gas pricing being at the current level, we're certainly shy of that $4 to $4.50 range that's required to generate increased utilization rates. So we'll -- we're certainly in the same position everybody else is, waiting for gas price economics to improve.

We'll take the next question from Brett Hoselton with KeyBanc.

First question. Just broadly speaking, you lowered your sales guidance by 4% to 5%, maintained your EBITDA and your free cash flow guidance. I guess what I'm wondering is normally, it's -- you'd see a little bit of leverage there. You've obviously been able to offset that in some way. Can you characterize some of the major offsets?

Brett, as we pulled the numbers together and certainly took this approach to our Q3 or second half guidance relatively conservative in terms of some of the margin pull-throughs for no reason other than to Larry's earlier commentary in terms of running the facility and production rates, being careful not to get ahead of ourselves -- and frankly, we've taken the same approach to the fourth quarter -- there are a lot of moving pieces in the fourth quarter, as we mentioned here on the call. And probably not all of them as well in terms of the variability. The uncertainty, in our view, is very high, certainly, than it was at this time last year. We have labor negotiations under way as well. So all those issues are certainly in the mix as we thought about the fourth quarter and trying to take more of a prudent approach in terms of margins.

And then switching gears. Just looking at kind of the cadence of sales into the fourth quarter, kind of continuation of what Joe was asking about here, but looking some of the other sectors. The non- North American Off-Highway, you're seeing a notable step-up in terms of sales going into the fourth quarter. It hasn't necessarily seemingly been the case in the prior 2 years. Is that just a continuation of your growth strategy? Or is it seasonality that maybe was masked in the previous years?

No, I don't think it's seasonality. I think it's a matter of gaining -- we've been working some accounts, and we were able to crack them. And particularly in China, there's been some nice volumes beginning to materialize there, which is what we said all along when we talked about even going back to the IPO, we said 3 things about the Energy sector. Number one, we said [indiscernible] in North America; number two, increasing demand driven by a variety of factors: utilities, vehicles, et cetera; and the third thing we said is when you look at our Energy business within the total Off-Highway end markets, if you look at the Energy end markets, you've got a component maybe that some do or some don't. And that is a non-NAFTA piece of that. We thought that, that was going to grow. And that was based on that we're -- what we understood to be the plans of some of those OEMs to release us. That has happened, and so it's kind of a -- albeit at lower volumes, it's kind of a light switch thing. You're selling nothing and then you start selling something. So that kind of accounts for the step-up. And they'll continue to -- assuming the product performs like we believe it should, we'll continue to make inroads there.

Help me think about the parts and support equipment section of the business. I mean, as I kind of look at the sales in the first to the second to the third to the fourth quarter and give or take kind of $5 million to $10 million decline in each of those quarters sequentially, and it looks like it's going to continue into the fourth quarter here, so how should I think about that business in terms of the go-forward?

There are several things that are in there. And it's -- and yes, does it add up? First thing is service parts, and you can think about that for both On-Highway as well as Off-Highway. And North America On-Highway, solid performance, fairly stable. Non-NAFTA service parts for On-Highway is growing. Their parts are growing as a result of the growth in sales we've had over the years here as we've continued to build that volume. The significant downside, I guess, the largest single one, is tied to the North America Energy sector. And as everyone was running the heck out of their equipment, they were buying a lot of parts to make sure it can keep going. As they've idled a fair amount of equipment while they are doing some refurbishment, and we know that for a fact, they do have a lot of equipment, as you all know from the studies you guys do, that's idled. And when it's idled beyond, they're refurbing some. So that's a good sign. They're not just completely sitting on their hands. But they're not refurbing at all, and so there is some equipment that sits idle, and they won't repair that until they have a need for it. So that's caused the drop-off. And then the other thing is as OEM -- the other piece that's in the parts business of significance is the what I'll call first installation or we call it support equipment. And that's really tied ratio-ed, right to the new unit sales. And as OEMs have reduced their schedules, we don't sell as many support parts there.

[Operator Instructions] And we'll go next to Rob Wertheimer with Vertical Research Partners.

I hope I didn't miss something simple, but it seems as though, on an earlier question, you lowered the revenues by whatever, 5%, and you kept the margins the same and also the cash flow the same, so am I missing something? Or can you help bridge the gap between that loss revenue dollars, same margins and same profit?

Sure, this is Dave. Look, a couple of things. As we approach -- and we're obviously building time here as a public company. Our approach in terms of EBITDA margins is typically to be more conservative on the ultimate pull-throughs there. That's even more so the case with fourth quarter given the moving pieces that we have. As Larry mentioned, still making decisions on shutdown days. We have labor negotiations under way. You have OEMs continuing to move around their schedules. Frankly, inventories are high, their inventories, it would appear, in certain respects. In the fields, we've assumed various things are going to be happening this quarter. And given the mix that we talked through in terms of guidance, when you pull that altogether, the margin guidance that we have for the fourth quarter, which is typically one of our weakest ones, is ultimately reflected there. So as we're working our way through the quarter, having almost one month under our belt, we feel pretty good about where we're at from a guidance standpoint there. And we'll see how the balance of these 2 months go, which doesn't seem like a long period of time. But given the amount of, I would say, uncertainty around the markets, we are taking a and continuing to posture ourselves in a more conservative way. The cash flow, as we thought about inventory levels certainly coming into the fourth quarter, some of that will ultimately fall out of the labor negotiating process in terms of how we end the quarter, as well as OEM take rates and whether they make any adjustments. As we talked about going into the third quarter, there was a heightened level of adjustments that had been made. We've seen the rate of some of those slow down a bit as we exited the third quarter. So from that standpoint, that feels a little bit better. That being said, I think that, as is typical, they're going to wait until they get further in the quarter to make some final adjustments for year end. So that's how we ultimately came up with the guidance that you see there.

Okay, great. And I think we -- we'll talk tomorrow, so maybe we can go through some of the arithmetic. One other question. It looks like the Off-Highway North America has gotten pretty bombed out. Do you -- are you able to say how much of that, if any, was new-build? Or are there any new-build tails in there? And do you think that the run rate on the aftermarket has dipped below what -- was there any de-stock? Was there any put-off? I mean, is the run rate in the aftermarket running with utilization? Or has it dipped below it temporarily?

I guess I would say, first off, to the first part of your question, there is certainly rigs being built. We know that for a fact, obviously, the reduced number compared to last year and compared to the blowout. I think all time record, in fact. Sales in the first quarter of this year, clearly that stepped down. Relative to the service parts, I guess I would say that we're probably -- and this is more of a feel because we ask people and it's very hard to get your arms around the total aftermarket. But I think we feel like we've kind of gotten to -- at least based on the current level of activity, diminished though it is, we think it's stable. We don't think it's running well below what they need. Now clearly, if activity picks up, they're going to need to get -- to the extent some of those rigs need some work, if they've got parts, they're going to need more parts. But that will be a little more gradual as they redeploy those rigs. So we think right now, the aftermarket is probably in balance with the amount of activity that's going on. Some of those rigs that are being refurbed are being sent to other places in the world. So I would say aftermarket imbalance, and there's clearly some new rigs being built. Not a lot, not as many as they were, but some rigs being built.

And if I can sneak in one more, and I'm sorry for this. But your gross margin performance really was great in the quarter. And obviously, revenue has accelerated. So how early in the quarter did you -- I mean, what was the pace like through the quarter? Did you get ahead of it right away? It was great management, I'm just curious how fast you anticipate it and how you are able to kind of pull it off.

Yes, we're pretty -- we're not perfect, okay? We can always do better. But we're a pretty tight organization. There's a every month what we call business performance review. Every one of my staff members is involved, and we go over all the key aspects of the business. We have a sales and operational planning meeting, and we go over the input from the OEMs. And we also have -- the major initiatives are all captured on what we call planning charters. And that's how we set up the budget in the first place, and that's our rheostat [ph] in terms of what if you see things are -- frankly, if things are starting to go better, you say, "Okay, maybe we can take on some our initiatives that will add value to the business." But if things are starting to get a little choppy, we're able to dial back up fairly quickly. There's not a salaried person who's hired here where a REC [ph] who doesn't cross my desk. So we're a pretty connected organization on understanding the environment. Now I there are tougher or easier environments to operate in, that's for sure. But certainly, it should not be for lack of awareness and lack of ability to make a conscious decision how we will react to a given circumstance. Okay. Well, thanks, everyone, for their time today. We appreciate your interest and support, and we'll keep those of you in the path of the hurricane in our thoughts. Have a good evening.

That concludes today's presentation. Thank you for your participation.