Cummins Inc. (CMI) Q1 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the First Quarter 2019 Meritor Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call may be recorded. I would now like to turn the conference over to Carl Anderson, Group Vice President of Finance. You may begin.

Thank you, Nicole. Good morning, everyone, and welcome to Meritor’s first quarter 2019 earnings call. On the call today, we have Jay Craig, CEO and President; and Kevin Nowlan, Senior Vice President and President Trailer & Components and Chief Financial Officer. The slides accompanying today’s call are available at meritor.com. We’ll refer to the slides in our discussion this morning. The content of this conference call, which we are recording, is a property of Meritor, Inc. It’s protected by U.S. and international copyright law and may not be rebroadcast without the express written consent of Meritor. We consider your continued participation to be your consent to our recording. Our discussion may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Let me now refer you to Slide 2 for a more complete disclosure of the risks that could affect our results. To the extent we refer to any non-GAAP measures in our call, you’ll find the reconciliation to GAAP in the slides on our website. Now I’ll turn the call over to Jay.

Thanks, Carl, and good morning. Let’s turn to Slide 3. We had a great first quarter, with total company revenue up $135 million from a year ago. Adjusted EBITDA margin was 11.5%, and we generated $0.79 of adjusted diluted EPS. Higher truck production, combined with market share gains in North America, drove the majority of the revenue increase. But we also had year-over-year sales growth in South America and India as well as in North American Aftermarket, Trailer and Industrial. Kevin will give you more color on the quarter, but we are obviously pleased to begin the year with such excellent financial performance. With our strong first quarter performance and a higher Class 8 market than previously expected, we are raising our revenue and adjusted diluted earnings per share outlook for the year. On Slide 4, we provided an update on the $200 million equity repurchase program we announced in November. You’ll recall that our Board of Directors had just approved this additional share buyback program following the completion of our previous program. In the first fiscal quarter of 2019, we utilized $50 million under this recent authorization to repurchase another 3 million shares, which now completes 25% of the new program. As we referenced last month at Analyst Day, since 2014, we’ve invested about half the Company’s free cash flow in share buybacks. With the strong cash flow we expect to generate for fiscal 2019, we will continue to be opportunistic in buying back our shares. As Kevin told you in December, we firmly believe that our ability to generate cash flow and deploy that cash to create shareholder value is the most underappreciated aspect of Meritor’s story. On the next couple of slides, we want to highlight the growth in our trailer, off-highway and specialty businesses. We have recently signed three significant contracts for new trailer business, as you’ll see on Slide 5. Last month, we told you about the three-year renewal with Wabash that maintains Meritor’s loose axles in standard precision on all Wabash Dry and refrigerated van trailer products. Also with this contract, the Meritor Tire Inflation System is the preferred automatic tire inflation system. Optional products for all Wabash configurations include air disc brakes, the trailing arm suspension and our recently launched MTec6 trailer axle. We’re also excited to announce today that we’ve signed a two-year agreement with Great Dain. This is a conquest win that gives us standard position for loose axles and automated slack adjustors. This is a meaningful award that allows us to strengthen our relationship with Great Dane in these product lines and also provides further revenue opportunity with this important customer. In addition, we now have standard position with Stoughton for loose axles and preferred position for MTIS. With these agreements, Meritor has solidified its position with three of the top six trailer manufacturers. Moving to Slide 6, you will see some examples of the growth we’ve achieved in off-highway and specialty. Growing these businesses is a key priority for us and our M2019 and M2022 plans. We announced in December that we had completed a strategic supply agreement with Manitowoc to supply a variety of drivetrain products for several types of cranes under its Grove brand. This conquest win is another step towards establishing Meritor as a leader in the commercial off-highway industry in North America. To that end, we’re also seeing more heavy haul fleets specking their vehicles with Meritor’s P600 planetary axle, which we specifically engineered for heavy haul oilfield, logging and mining applications. RyTy Developments, which provides heavy hauling and off-road transportation services for the Canadian gas and oil industry, recently became the first fleet in the region to order their Kenwood trucks with our P600 axle. The strength and reliability of Meritor’s off-highway products, combined with our vertically integrated short lead times, ready access to service and support with 24-hour part availability and our long-standing relationships on the line haul side of the business, are driving demand for Meritor’s off-highway drivetrain solutions. On the specialty side of the business, we mentioned in December that we are supplying a unique transfer case for Navistar on the launch of its international CV Series Class 4 and 5 truck. These trucks will feature Meritor’s two-speed, gear-driven transfer case with 3,000 pound per foot capacity and electric shifting controls. We are the first to market a gear-driven transfer case for this class of trucks. We have started production of this product in our Laurinburg plant in North Carolina where we have made a significant investment to support the expansion of our Industrial business. Shifting next to electrification on Slide 7. We were proud to be featured at the recent CES technology show as Peterbilt unveiled its new Class 6 pickup and delivery truck. With CES being the global stage for next-generation innovations, it was exciting to be highlighted as the supplier in collaboration with TransPower of Peterbilt’s 220 elective drive system shown here with Peterbilt’s Head of Engineering. Our relationship with TransPower continues to grow with an additional investment we recently made into the company. The full system solutions available through TransPower as well as our own proprietary eAxle currently in development makes Meritor an excellent choice for electric vehicle manufacturers around the world, which is evident by our growing customer base. In closing, I’m pleased with our performance in the first quarter and with our outlook for the fiscal year. We are on track to achieve another successful year in 2019. Now I’ll turn the call over to Kevin for more detail on the financials, and then we’ll take your questions.

Thanks, Jay, and good morning. On today’s call, I’ll review our first quarter financial results and our updated 2019 guidance. Overall, as you heard from Jay, we delivered a strong start to the final year of our M2019 plan. We drove increases in revenue, adjusted EBITDA, adjusted EBITDA margin and adjusted EPS. Let’s walk through the details by turning to Slide 8 where you’ll see our first quarter financial results compared to the prior year. Sales were $1,038,000,000 in the quarter, up $135 million from a year ago, driven primarily by higher truck production and increased market share. The largest increase came from North America with Class 8 production up 24% compared to last year. In Brazil, the truck market recovery continues with Q1 production up 21% this year. And finally, growth in our other North American businesses, Aftermarket, Trailer and Industrial also contributed to the rise in sales. As you can see from the causal on the right, we converted on this revenue at about 16%, which is in line with our normal expected range. Included in this conversion is higher earnings performance at our unconsolidated joint ventures, which are also capitalizing on the global market conditions. This conversion was partially offset by FX headwinds from the strengthening U.S. dollar, which reduced sales by $26 million and adjusted EBITDA by $6 million compared to the prior year. The result is that we generated adjusted EBITDA of $119 million with an adjusted EBITDA margin of 11.5%, a 50 basis point expansion over last year. Gross margin came in at 13.6% this quarter, down from 14.6% a year ago. Operating at these production levels and in this overall market environment, we have seen some pressure on gross margin, primarily driven by higher material, freight and other premium costs. We do expect gross margin to recover throughout the year as we have not yet fully recovered the increases in steel costs that we experienced in the latter half of 2018. Additionally, we expect to see some benefit from pricing actions in our Aftermarket business that were implemented in January to mitigate such costs. One more point on gross margin. Due to a recent accounting standard update that we implemented this quarter, you’ll notice that our gross margin for both this year and last year now reflects the removal from operating expenses of the non-service cost component of our pension and retiree medical expense. These amounts have been reclassified to the line item other income on our income statement. As you move down the table on the left, you’ll see that we’re reporting $90 million of GAAP net income from continuing operations, which is significantly higher than last year. There were two key drivers to this increase. Last year, we recognized $77 million of non-cash tax expense arising from the enactment of U.S. tax reform. And this year, we recognized a $31 million gain from remeasuring the Maremont asbestos liability. I’ll be discussing this in more detail in a subsequent slide. Adjusted income from continuing operations, which excludes the impact of both of these items, was $69 million, resulting in $0.79 per adjusted diluted share, a 27% increase over last year. And finally, free cash flow was negative $12 million this quarter compared to an inflow of $15 million in the same period last year. Higher adjusted income was more than offset by increased incentive compensation payments due to our 2018 financial performance, investments in inventory to support stronger revenue and increased capital expenditures as we invested more in supporting our growth opportunities. Let’s move to Slide 9, which details our first quarter sales and adjusted EBITDA for both of our reporting segments. In our Commercial Truck & Trailer segment, sales increased by 16% to $824 million. The increase in revenue was primarily driven by higher truck production in North America and increased market share. Unfavorable foreign currency impacts due to the strengthening dollar only partially offset these gains. Segment adjusted EBITDA was $79 million, up $10 million from last year. Segment adjusted EBITDA margin for Commercial Truck & Trailer came in at 9.6%, roughly flat compared to last year. The increase in adjusted EBITDA was driven primarily by conversion on higher revenue, partially offset by higher material and freight costs, SG&A expense and FX. In our Aftermarket & Industrial segment, sales were $257 million, up 12% from last year. This increase was primarily driven by our North America aftermarket, specialty and defense businesses. Segment adjusted EBITDA was $38 million, an increase of $6 million or almost 20% compared to last year. Segment adjusted EBITDA margin grew 80 basis points to 14.8%. This growth was driven primarily by conversion on higher revenue. On Slide 10, I wanted to provide an update on the actions of our non-operating subsidiary, Maremont. Recall that in December, we announced that Maremont was seeking to create a trust under Section 524(g) of the U.S. Bankruptcy Code to resolve all correct and future asbestos claims. Last week, we announced that Maremont and its subsidiaries voluntarily filed cases under Chapter 11 of the U.S. Bankruptcy Code. The remaining key actions include confirmation of the reorganization plan by the courts and funding of the trust, primarily with a $28 million contribution and the repayment of an approximately $21 million intercompany loan by Meritor. As a result of this initiative, we recorded a $31 million gain in the first quarter as we remeasured Maremont’s net asbestos liability to the terms of the reorganization plan, which now represents the best estimate of the liability. Once the bankruptcy process is complete, these actions are expected to eliminate approximately 70% of net asbestos liabilities from Meritor’s balance sheet. Next, I’ll review our updated fiscal year 2019 global market outlook on Slide 11. Although we saw some softening of Class 8 truck orders in December, the backlog is still almost 300,000 units. This gives us confidence that production levels should remain elevated for the rest of our fiscal year. Therefore, we are increasing our production estimate by 10,000 trucks to approximately 330,000, driven primarily by our expectations for a stronger fourth quarter than we were previously anticipating. Our forecast for the remainder of our market is unchanged, so we are keeping volume assumptions at our prior guidance levels for all of these other markets. Overall, solid to strong global end markets continue to support our positive outlook for 2019. Based on these updated assumptions, you can see we are raising our guidance on Slide 12. We now expect revenue to be approximately $4.3 billion, up $50 million from our prior guidance. We are maintaining our outlook for adjusted EBITDA margin at approximately 11.5%. In light of our stronger revenue outlook and the incremental conversion we’re able to generate, we are modestly increasing our investment to support our electrification initiatives. This incremental investment is offsetting some of the margin conversion from our higher-revenue guide. In addition, as you think about Q2, we do expect to see our normal seasonal trend of increasing revenue sequentially. However, with the strong production levels we experienced in our first quarter, we expect the sequential step up to be much more modest in the next couple of quarters than we see in most years. For that reason, you should expect any sequential step-up in EBITDA margin to also be relatively modest. With stronger top line revenue, we expect to generate an increase in adjusted income from continuing operations. This higher income, coupled with the repurchase of 3 million common shares we executed in Q1, is expected to drive adjusted diluted earnings per share from continuing operations of approximately $3.30 per share, an increase of $0.20 from our prior guidance. This puts us close to $0.50 above our M2019 target. And finally, we are maintaining our free cash flow outlook at $175 million to $185 million. The increase in earnings from revenue growth expected in Q4 is expected to be largely offset by a corresponding increase in working capital investment, which yields no change to our free cash flow guidance for 2019. As we discussed at our Analyst Day last month, this is the level of cash performance you should expect from Meritor to generate as we transition from M2019 to M2022, and it’s this level of cash generation that supports our M2022 capital allocation priorities as we focus on investing in strategic growth and returning value to our shareholders. We’re excited about the positive start to this year, which puts us on the path to successful conclusion of our M2019 plan. Now we’ll take your questions.

[Operator Instructions] Our first question comes from the line of Ryan Brinkman of JPMorgan. Your line is now open.

Hi, great, thanks. I was wondering if you could provide some more color in your business in China, including after Caterpillar missed earnings the other day, setting a slowdown in that market. I see on Slide 6 that your sales in China actually surged in 2018, but just curious if you’re seeing any of the same slowdown more recently. And maybe if you could remind us of some of your more unique customer end market exposures within China we should be thinking about in the current environment.

Yes, good question, Ryan. We’re still expecting the market to be flat this year as compared to last year. The segments we’re involved in, such as with XCMG, in construction are holding up similar to what we saw last year as far as the infrastructure projects and their product support. And then we tend to be at the higher end of the quality spectrum on the on-highway. And so far, that’s performing very similar to what it did last year.

Okay, great, thanks. Just lastly for me too, I was hoping you could comment a little bit more on the market share gains. You’ve had several in the Trailer segment. Just curious who you’re winning these from, and what the outlook is going forward.

Well, I’ll begin that. I’m actually going to ask Kevin to talk a little bit about Trailers since he’s leading that business for us. And he and the team have done an excellent job of getting our product development strategies aligned with what the customer markets are demanding, and I think that’s starting to show in that three wins we talked about today.

Yes, as it relates to Trailer, I mean, the performance that we’re generating in terms of seeing some market share gains are being driven by our strong delivery performance as well as our high-quality product. And so we continue to be the leader in that trailer market in terms of supplying loose axle and among the market leaders in tire inflation. So strong product, strong delivery performance and strong quality have been supportive of us gaining share there.

Very good, thanks.

Thank you. Our next question comes from the line of Joe Spak of RBC Capital Markets. Your line is now open.

Thanks. Good morning, congratulations.

Thanks, Joe.

Just maybe we could start in Commercial Truck. First of all, I’m sorry if I missed this, I was wondering just how much of an FX headwind was in that segment this quarter. And then back at the envelope, it looks to us like maybe 75% to 80% of the organic growth was from what I’d call market and then maybe the rest was sort of your new business and end market share gains. Is that – do you roughly agree with those numbers?

On the market share gains, I have to come back to you. It’s probably in the ZIP code. I mean, we had tens of million dollars – tens of millions of dollars of revenue outperformance as I look Q1-to-Q1 on a year-over-year basis. I didn’t do the math to see is that 25% or so, but it’s probably in that ZIP code somewhere.

Okay.

And with respect to the question on FX headwind, the bulk of that headwind is in the Commercial Truck & Trailer segment because the Aftermarket & Industrial business is predominantly in North American business. They have some European exposure, but it’s predominantly a North America-based business.

Okay. And you said it was $26 million. Is it what? For the total company? Was that the number?

Revenue of the whole company, $6 million of EBITDA. That’s right.

Okay. And then just in Aftermarket, if I recall correctly, I think you were sort of taking some pricing actions there because that was sort of the area where you were able to offset some of the raw material movements. Is that what occurred? And how – and if so, how much did that contribute in the quarter?

Yes, I mean, part of what we executed in the middle of last year, in July of last year, we did execute some pricing actions to mitigate some of the costs that we were seeing from a steel perspective and a freight perspective. And as we started this new calendar year in January, we’ve continued to execute pricing actions to reflect any market economics that we’re seeing. I’d also point out in that segment, the Industrial business is performing well as well and saw some growth and contributed to margin growth there.

Okay, and maybe just a follow-up then. And I think you were sort of – previously, sort of talking about this business that could get sort of 14%, 15% margins, but I think that was before you made some reporting changes. So is there any additional sort of color you’re willing to provide on sort of what you think the right or the ultimate sort of margin potential of the Aftermarket Industrial business is?

Yes. I think you, obviously, saw a big step-up in margin on a year-over-year basis, 80 basis points. We expect that business to operate north of 14% each quarter as we look ahead through 2019, and that’s a step-up from what we saw a year ago because we did have a couple of quarters in the middle of the year where we operated below 14% on a fully loaded basis. So we are expecting to operate north of 14% in that business for the year.

Okay, thank you very much.

Thank you. Our next question comes from the line of James Picariello of KeyBanc. Your line is now open.

Hey, guys. So for your joint ventures, I mean, you had a solid quarter for equity income. Just wondering if you could talk about – you have, I think, four primary joint ventures at this point. Can you talk about what drove the upside in the quarter and how are you think about the rest of the year?

Yes, I think – thanks, James. I think you can think about those joint ventures really seeing the benefit of the end market increases and market share gains that we talked about. So we have our Mexican joint venture, Sysmex, for example, that shared in the growth we saw in North America. We’re seeing the recovery in Brazil, and that bring Masters, our braking joint venture’s results along with that. And then we’ve talked about the strength of India as well, and so we have our significant joint venture there with the Kalyani Group. So it’s pretty widespread, just those joint ventures participating both in our market share gains and the end market increases.

Yes. On the topic of India, you have new missions, standards hitting. You also have a mandatory forced aging of the fleet of replacement greater than 20 years or older. So what’s your outlook on the timing of when you might see some significant prebuy ahead of both of those factors in the market? And are you already seeing it? Or right now, is this – would you chalk this up to just strong market demand?

I think it’s really primarily strong market demand, I think, if we would expect may be late in 2019. But remember, India does have some history of pushing off those deadlines because the market at times cannot ramp up capacity to meet the demand required for those changes in regulation. And we are making some modest increases in our capacity through our joint venture to make sure we’re ready for that. But I would say it, we would expect at earliest to see the impact of those changes in late 2019.

Got it. Appreciate it. Just last one, if I could. Have you guys quantified the commodity headwind that you expect for FY2019 in terms of the incremental impact? That’s it. Thanks.

Yes, I mean, in the first quarter on a year-over-year basis, it had a few million dollars of negative impact on us. Remember, steel indices are actually up, particularly in North America, year-over-year anywhere from about 20% to 30%. Now most of that increase happened in the latter part of 2018, so it’s really just a delay as our recovery mechanisms start to kick in. And we’ll start to see some sequential tailwind from that heading into Q2. But if you take a step back, in totality for the full year, 2019 versus 2018, we expect steel to be a headwind on a net basis high single-digit millions, and that’s embedded in our guidance.

Thanks a lot.

Thank you. Our next question comes from the line of Mike Baudendistel of Stifel. Your line is now open.

Thank you. Can you give us some sense, I mean, these contracts seem pretty significant on the trailer side, just what – how big those contracts are in terms of revenue? And sort of how that fits into your plan to outperform the market?

It’s – this is Kevin, I’ll speak to that. It’s a mix. I mean, a couple of those are solidifying existing positions that we have, particularly with Wabash and Stoughton, although they position us to grow with certain product categories with those key customers. In the case of Great Dane, there is some conquest business there that we achieved on loose axles and slack adjustors. So important growth opportunities for that trailer business.

Got it. So it’s a mix of the two. I guess, can you also – just getting back to the materials cost, can you sort of explain why that seems to be impacting the margins on the Commercial Truck & Trailer side but not the Aftermarket side? And when does it start to be a neutral or – on a year-over-year basis?

Well, for Commercial Truck, remember, we have recovery mechanisms with our OE customers that kick in generally on about a six-month lag. So as we saw steel indices increasing towards the back half of our fiscal year 2018, those mechanisms simply haven’t had a chance yet to kick in. With Aftermarket, Aftermarket updates its pricing periodically once or twice per year based on overall macroeconomic conditions inclusive of steel. And so the Aftermarket started pricing for that back in January – or back in July of last year and started to see some recovery from the mechanisms from the increase in steel indices that we were seeing last year. So they saw a little bit of an improvement sooner than the truck business.

Got it. That makes sense. That’s all I had this morning. Thank you.

Thank you. Our next question comes from the line of Colin Langan of UBS. Your line is now open.

Thanks for taking my questions and congrats on a good quarter.

Thank you.

More of an accounting question, but there was $11 million of other income, which typically, that’s only a couple of million or zero. Any color on what that is in the quarter and whether that’s a sustainable number?

Yes, Collin, this relates to an accounting standard update that we had to implement this quarter. So it’s actually the reclassification of non-service cost component of our pension and retiree medical expense. So that’s about $9 million that we moved out of gross margin or cost of goods sold that’s actually income and moved down to other income. We actually recast 2018’s numbers as well. So you’ll see that went from a number that was de minimis to now it’s a positive $8 million in Q1 of a year ago. So that’s simply an accounting change that we had to make that impacted both last year and this year.

Got it. Okay, that makes sense. And then when we think of share repurchases, those $50 million in the quarter, is that the pace that we should be thinking about for the rest of the year? Is that – or will it move around through the year?

I think you should remember, Colin, as our cash flows tend to be seasonal, where we generate a meaningful portion of our free cash flow in Q3. And then we do have some other obligations, one of which Kevin spoke to, the funding of the Maremont liabilities that we think are upcoming. So we saw a great opportunity in Q1, given the price at which our shares were trading and we felt highly confident on our free cash flow projection for the year. So we decided to lean out a little in Q1 and take advantage of that market disconnect in our valuation.

Got it. Any – can you just remind me of the $200 million authorization for the next two years? Is there a time line on that?

The $200 million authorization is open to be able to support repurchase activity through our 2022 planning horizon. And so it’s just the initial approval that we’ll execute on as we generate free cash flow and we see the opportunity to deploy cash accordingly. So at this point, we’re $50 million utilized of that full $200 million, 25% done, but we’ll continue to execute as we see opportunities to deploy cash accordingly.

Got it. And just lastly, any update – we covered most of the regions other than South America. I mean, any update on that business? I think you were expecting a small increase. Is that still on track? And how should we think about the potential there with maybe higher incrementals because of the low base you’re off of?

Well, we are seeing a pretty measurable increase year-over-year, over 20%, and what we expect in the market, 18% to 19%. And we still feel confident in that. So I think we’re feeling good about that. And the market with the new government in place, the confidence seems to be developing in the country. And I would say, we’re considerably more optimistic on that market recovering to more normalized levels.

Got it. Thanks for taking my questions.

Thank you. Our next question comes from the line of Brian Johnson of Barclays. Your line is now open.

Yes, good morning. I have question is on two fronts, just some of the margin in Aftermarket and then on EVs. On the margin, I think you alluded to this, but what – is what we can take away from the lack of freight, SG&A and material offsets in Aftermarket – in the Aftermarket Industrial business that it’s just shorter cycle pricing and you’re able to move those factors up and down, so you just – it’s just basically straight incrementals there?

No, I’d actually say it’s more because we’ve reacted to what we’ve seen in the market from escalating costs throughout 2018, and we executed some pricing actions in July of last year to mitigate the impact of those. So we have seen increased freight costs last year in 2018 and other economic factors, and we’ve been pricing for it.

Okay. Secondly, over on the EV front, we know you guys have 22 prototype programs out there. Is there any kind of way to bucket what you’re spending the EV money on? Is there kind of a core technology that you spend on across all those programs? Is it just on each prototype? Or kind of any way to kind of think about that? And then how that might progress if any of those actually move closer to production?

Yes, I would say, Brian, we’re spending, you could say, approximately $10 million this coming year on both our pure R&D and also prototype development where we’re not receiving reimbursement from customers. So in certain cases, we do receive reimbursement from the customer for partial reimbursement of the cost we’re incurring. But as Kevin mentioned in his remarks, we’ve seen such great opportunities there. We’ve ramped up the spending a bit from what we had initially expected because of how well the company is performing and the opportunities we’re seeing.

Okay, thank you.

Thank you. Our next question comes from the line of Neil Frohnapple of Buckingham Research. Your line is now open.

Hi, thanks and congrats on a great quarter. First, I just want to round out the EBITDA margin discussion for the year. So I mean, you guys just delivered an 11.5% adjusted EBITDA margin, well above expectations in, again, what is historically, I think, the seasonally lowest quarter of the year, so great performance there. So could you just talk about some of the puts and takes from a margin perspective for the remainder of the year to get to the 11.5% full year guidance. I know you guys cited the increased investment in electrification, but on the flip side, it sounds like you’ll get maybe a sequential tailwind in Q2 from steel, the pricing initiatives in Truck & Trailer and then expect higher gross margins, I think you said so. Again, just wanted to round that out, and if you could provide more color, that would be great.

Okay. Thanks, Neil. Definitely, I mean, we’re pleased with the fact that we started the first quarter strong. 11.5%, up 50 basis points year-over-year is a strong first quarter for us. As we look ahead, the first thing I would just mention is that, typically, our second and third quarter, we see a much more robust step-up from a revenue perspective than what we would expect this year because Q1 was so strong from a revenue perspective. And take last year, going from Q1 to Q3, revenue was up $200-ish-plus million from one quarter to the third quarter. This year, we expect it to be up less than $100 million. So there’s a lot less conversion opportunity as you go from one quarter to the next. But we are expecting to continue to convert on that incremental revenue. So you see a little bit of upside in margin from that, but then being offset by some of the additional electrification investment that we’ll be making over the next couple of quarters, starting in our second fiscal quarter. So net-net, we still expect to be around approximately 11.5% for the full year, but pretty pleased with the start to the year.

Okay, thanks for the color, Kevin. And then with NAFTA Class 8 production this past quarter coming meaningfully higher than expected due to a surge in build, I think, in the month of December, did that require you to more over time and things like escalated freight cost to serve the market, which may have laid on Commercial Truck & Trailer margin in the quarter? And I guess just curious on relative to what you’d expect for the rest of the year.

The short answer is, yes. We continue to see – so continuing less-than-optimal efficiency in our operating plans and also some additional premiums as we expedite freight. They were within our planning assumptions. So – and we do have some expectations for the rest of the year that we are running some layered capacity as we speak to it on the margins of our supply relationships. And we have embedded in the guidance that Kevin updated the cost of those additional expedited freight and layered capacity suppliers.

Okay. Great, thank you so much, guys.

Thank you, Neil.

Thank you. Our next question comes from the line of Alex Potter of Piper Jaffray. Your line is now open.

Hi, thanks. Good job in this quarter, guys. I guess, I have one additional question on electrification. Deploying more capital for that opportunity, which is a good sign. I’m interested to know if this is something that you’re doing opportunistically because you’re doing better than what you thought, revenue is higher, margins are higher, so you can redeploy some capital. Or is that something that you would have likely done anyway?

Well, that’s a good question. I think we, in my mind, probably would have done it anyway but would have had to allocate where different investments would have been reduced. I think with the good news we’re seeing in the business, we’re able to continue to deploy capital to all the opportunities we’re seeing and increase that investment in electrification. I think, as you know, under this leadership team through M2016, 2019 and now 2020, we take the targets that we set very seriously and try to manage all our different puts and takes within those targets. But certainly, because of the strength we’re seeing in our business, we were allowed to continue to make all the investments required.

Okay, very good. And another question on China also. I know that historically, you’ve got more of an off-highway focus. You mentioned more – when it comes to the on-highway side of the business, there’s more premium high end. But my understating is that that’s also – one of the goals of the company, I suppose, is to increase exposure to the on- highway segment there. It’s a area that you’ve historically been under indexed. Is that – has there been any development in that regard? What do you expect over the next one, two, three years?

Yes, there have been developments. What I’m pleased with is, we have an excellent disc brake offering in China. So we’re starting to see opportunities there that are coming forward. In our core axle business, we continue to see opportunities on the premium side of the market. So the one caution I would give us, we will not derogate the margins of the overall company by chasing opportunities in spaces in that market that just don’t have the returns required. And that’s been our challenge over the years is that market has not had the returns for suppliers in our segment that have been acceptable to us. So we’d – that’s why our growth strategy has been more measured maybe than others.

Okay. Yes, that makes good sense. And then my last question, I guess, related to the supply chain in the U.S. Still, there’s, as you mentioned, expedited freight, over time, things of that nature. Do you think the supply chain is properly capacitized at this point? Or when do you think that people have their upstream or downstream or whatever the supply bottlenecks are, do you think that more investment is likely to be earmarked to address those bottlenecks? Or do you think we’re basically just going to be dealing with the current situation indefinitely until the backlog runs down?

I’ll give a few brief comments and ask Kevin to provide additional detail. But as we spoke to previously, we’ve increased some capacity in North America just beginning coming online here in January. And that capacity, directed at the Class 8 market, was – the investment was primarily directed at our supply base just trying to bring on more capacity and different suppliers. So we continue to monitor very closely but have to make some incremental investments to bring on that additional capacity.

And this is Kevin, I’ll just – I don’t have much to add. I mean, it’s – I don’t anticipate seeing a significant step-up in investment beyond that. I think the modest investments we made in some supplier tooling to support the strong market that we anticipate, at least through the balance of this fiscal year, I think that’ll carry us through this year. But I’m not expecting to see more from the way of capacity investments beyond that at this point.

Okay. Nice job again, guys.

Thanks, Alex.

Thank you. And our next question comes from the line of Faheem Sabeiha of Longbow Research. Your line is now open.

Hi, good morning guys and congrats on a good quarter. Just wondering, with the acceleration in share repurchases in Q1 and the funding of the Maremont trust coming up soon, can you maybe talk about your appetite to maybe use debt to make an acquisition if one were to come up over the next quarters?

Well, I think the question we ask ourselves is and the answer we provided in the rollout of the 2022 plan is we’re very pleased with the core business and our ability to grow organically. So we continue to look at opportunities and acquisitions that are more bolt-on in nature. And really, we do not believe we are interested in a transformational acquisition of the scale that would take us off track on our capital allocation strategy that we laid out in the December Analyst Day. So we have a significant number of opportunities we’re constantly evaluating, but those tend to be bolt-on in nature.

Okay. And final question for me. Can you talk about other opportunities for your gear transfer case within the Class 4 and 5 market, given the success you had getting on the platform with GM and Navistar, or maybe any other adjacent markets to that?

Well, we do see the investment we’ve made and the development of that transfer case and also a brand-new assembly line in our Laurinburg facility that I spoke about on the call as an opportunity to look at additional market share gains in that area. So we don’t – I don’t see anything specifically that will be announcing in the near-term, but we certainly are continuing to make headway in that market. And I think it’s very unique technology that Navistar appreciated, and I think the end market will appreciate as that vehicles rolled out here over the next few months.

Okay. Thanks.

Thank you. And I’m showing no further questions at this time. I’d like to hand the call back over to Carl Anderson for any closing remarks.

Thank you. This does conclude Meritor’s first quarter 2019 earnings call. If you have any follow-up questions please feel free to reach out to me directly. Thank you.

Ladies and gentlemen, thank you for participating in today’s conference. That does conclude today’s program. You may all disconnect. Everyone have a great day.