Dana Incorporated (DAN) Q3 2017 Earnings Report, Transcript and Summary

Good morning, and welcome to Dana Incorporated's Third Quarter 2017 Financial Webcast and Conference Call. My name is Dennis, and I will be your conference facilitator. Please be advised that our meeting today, both the speakers' remarks and Q&A session will be recorded for replay purposes. There will be a question-and-answer period after the speakers' remarks, and we will take questions from the telephone only. [Operator Instructions] At this time, I would like to begin the presentation by turning the call over to Dana's Senior Director of Investor Relations and Strategic Planning, Craig Barber. Please go ahead, Mr. Barber.

Thanks, Dennis. And thanks to everyone on the call for joining us today for Dana's third quarter 2017 earnings call. Copies of our press release and presentation have been posted on Dana's investor website. Today's call is being recorded and the supporting materials are the property of Dana Incorporated. They may not be recorded, copied or rebroadcast without our written consent. We will end our call today with a Q&A session. In order to allow as many questions as possible, please keep your questions brief. Today's presentation includes forward-looking statements about our expectations for Dana's future performance. Actual results could differ from those suggested by our comments today. Additional information about the factors that could affect future results are summarized in our Safe Harbor statement. These risk factors are also detailed in our public filings, including our reports with the SEC. Presenting this morning are Jim Kamsickas, President and Chief Executive Officer; and Jonathan Collins, Executive Vice President and Chief Financial Officer. Jim turn the call over to you.

Thank you, Craig. Good morning, everyone, and thank you for joining us for Dana’s third quarter earnings call. Today, we will update you on our strong results, how we're progressing on our shifting into overdrive enterprise strategy and Dana's outlook for the rest of this year as well us some color on how we see next year shaping up. It was another strong quarter for Dana with sales of $1.8 billion. That's a 32% increase over last year, 21% of which was organic growth. This is our third consecutive quarter that we've achieved double-digit year-over-year organic growth. Our strong sales backlog, combined with recent acquisitions and improved end market demand, continue to drive our profitable growth. Our adjusted EBITDA came in at $216 million or 11.8% margin in line with the previous quarter. Diluted adjusted EPS increased 20% over last year's third quarter to $0.59 per share due to stronger earnings. Free cash flow was also strong at $99 million, driven by our higher earnings. And again, this quarter, we are raising our full year 2017 financial targets from our prior guidance, including an additional $200 million in top line growth. As we've done in previous calls, I would like to take a few minutes to update you on the advancements we continue to realize relative to executing our enterprise strategy. This quarter, we will specifically appraise you of our progress regarding customer-centricity, electric vehicle program developments and our expansion in China where we're leveraging our core assets and technology. Before we get started, I usually do not reference application pictures we use on the Highlights slide. But this quarter, we thought we would change things up a bit by illustrating a few unique vehicles that you may have seen but didn't know that they utilize Dana product solutions. Starting at the top with the Luxgen7 MPV electric vehicle, which is in production in China. This vehicle utilizes Spicer electrified drive unit. This electric SUV has been in the market for several years and was one of our first light vehicle EV platforms. Next, you can see the bright red truck on the streets of London today. This is the new electric Royal Mail Truck that uses a Dana's Spicer drive shaft in a central electric motor configuration and has a range of 100 miles, perfect for the mail delivery application. Next, you will recognize these toll tractors almost every time you board a commercial flight. So the next time you see one, you will know that it's likely running on Dana drivelines. Finally, everyone knows the iconic yellow of Caterpillar construction equipment. Like the Compaq wheel loader shown here. And yes, you guessed it, Dana supplies the transmission and axles for this vehicle as well. Again, I highlight these vehicles not because they make up a large percentage of our sales but because they demonstrate the breadth of our product reach while leveraging our core technologies across our end markets. Please turn your attention to Slide 5. Being recognized by our customers and industry leaders further demonstrates Dana's ability to commercialize new technologies and work collaboratively to create value while executing and delivering on our commitments. Consistent with previous earnings calls, I will follow the same approach by allowing our enterprise strategy to service the outline for the business update today. As you are likely to be aware, the second year in our strategy is customer-centricity. Part of focusing on the customer is understanding what the voice of the customer is telling you. Accordingly, as we reflect back on the very recent past, not only have our customers been communicating their appreciation for our performance but so have numerous independent industry associations. I promise not to cover all ten of the examples on the recognition page, but I will take a moment just to draw attention to a few. Starting with a very important industry recognition. Only 12 days ago, Dana was nominated for a 2018 Automotive News PACE Award. This is the seventh consecutive year that Dana has received a nomination, not something that is easy to accomplish. This recognition was for Dana's new highly engineered constant-velocity joint, the first use of a constant-velocity joint in heavy-duty pickup trucks. Rzeppa-style CV joint provides a durable solution for heavy-duty pickup trucks, offering efficiency in tough conditions while reducing weight. Congratulations to our team of world-class engineers on receiving this prestigious nomination. Transitioning to a unique customer award, please notice the four circle on the top half of the slide. Ideal Lease is one of the largest commercial vehicle rental and leasing companies in North America. They recently recognized Dana for our Spicer OpTiMa tire management and Rambus tire analytic system. Both of these systems are integrated into current production trucks purchased by Ideal Lease and are recognized as industry-leading solutions that help reduce the total cost of ownership for fleet operations. Finally, for the third consecutive year, Dana was honored with the Sustainability Best Practice Award in 2017 for our battery-cooling technology in China. Our battery-cooling technology supports Dana's strategic initiative to accelerate hybridization and electrification while supporting the 2040 Shanghai Vision for Sustainability. From the PACE nomination to these other major innovation and execution awards across all four of our business units, these acknowledgments truly demonstrate our continued commitment to driving one of the key principles of our enterprise strategy, customer-centricity, and our commitment to be a supplier that provides great value across the global markets which we serve. Please turn to Slide 5 for the fifth element of our enterprise strategy: accelerating hybridization and electrification. Spicer Electrified services our product brand for electric driveline products. This also represents Dana's comprehensive strategy to leverage our decades of controls, software and electric engineering expertise and product knowledge. Dana has provided mobility markets with electric – electrified products for decades. And this experience serves as a tremendous enabler to accelerate both our hybrid and electrified product development. Speaking with examples, you will see on the left side of the page an electric drive unit for electric vans, which manages speed and torque from the electric motor to the wheels. Currently in production in the United States this design allows for vehicle systems integration, reduces weight and improves efficiency. Transitioning to the center of the page. Planned for launch in 2018 in China is a new E Axle for electric transit buses and city delivery vehicles. This E axle features a fully integrated motor and gearbox. It's truly exciting to witness our global engineering team members across all of our business units and geographies efficiently working together to leverage our collective product development experience and best practices. The rate of change in this area is accelerating, and Dana is welcoming the opportunities that come in this exciting, new environment. And finally, on the right-hand side of the page, highlighted is some of our advanced battery and power electronics cooling technology. Our Power Technologies team has made significant progress in the Asia-Pacific region. As an example, I'm happy to announce a significant new business win in China with a major OEM for both an electric SUV and passenger car program. These products will be manufactured in our Wuxi, China facility and will be our first battery coolers domestically produced. This service is our foundation and springboard to assist in growing our EV market share in this important region. The China market was responsible for nearly half of all plug-in electric vehicles sold in the world last year, and they have established ambitious goals for further adoption of hybrid and electric-powered vehicles in the decades to come. With more than 25 years of supplying innovative products to the domestic Chinese market, Dana will continue to engineer advanced technologies to improve fuel efficiency and reduce emissions. Dana, with over 30 facilities in Asia – 35 facilities in Asia-Pacific, is strongly positioned to assist OEMs as they design vehicle programs for the future and on the numerous growth opportunities in this important region. Moving to Slide 7. I'd like to continue the update of Dana's growth specifically in China. China will continue to be an important and expanding market for Dana. Each of our business units are doing a great job growing their businesses, and accordingly, we are strategically adding capacity in the region. Our Brevini acquisition earlier in the year added two additional off-highway drive and motion facilities in China to the Dana family. One key element of our synergy plan is to institute Dana's operating system in all of our operations, which will drive increased efficiency and importantly, manufacturing floorspace generation. By doing so, we have been able to consolidate the former Brevini China manufacturing sites into a single facility, allowing us to utilize a second facility for our Power Technologies group. We have been repurposing this facility over the past couple of months, and we have begun to install PTG's new, highly automated equipment, commenced training of employees and readying for full production in early 2018. This is a great example of our effort in key members' passenger support growth and lower costs by levering our cross business unit core assets and capabilities. Earlier this year, we announced that we are building a new manufacturing facility in Chongqing, China. Scheduled to open in late 2018, the plant will manufacture drive units with the integrated Spicer SmartConnect disconnecting all-wheel-drive technology as part of the global vehicle platform for a major auto maker. The introduction of our disconnecting all-wheel-drive technology in China illustrates how Dana is executing enterprise strategy. The Spicer Smart Connect system helps to expand the markets by driving disproportionate growth in this rapidly-changing Asia-Pacific region, while commercializing new technology – technologies that address customer and market needs. Please turn to Slide 8 for an overview on market conditions. In North America, the U.S. economic growth continues to be a positive indicator for our end markets. Light truck production is expected to remain strong through the rest of the year while our key platforms continue to see stable demand. Class 8 truck production is now forecast to be higher in the range of 245,000 to 255,000 units this year in North America. And the steady improvements we have seen in construction and mining end markets continued during the third quarter. We expect this trend to carry into 2018. In Europe, we expect economic growth will continue through the remainder of 2017, and our currency expectations have improved as the euro has strengthened against the U.S. dollar. The commercial vehicle market has shown a solid 2% growth, with the off-highway markets remaining strong. And you can see the flow through coming in our off-highway drive and motion business unit. Moving to South America. In Brazil, we saw continued slow recovery during this quarter and expect this to carry on into next year. Off a low base, medium and heavy truck production has increased more than 20% year-to-date, while bus production continues to stabilize. In Argentina, we expect the economy to remain stable. Lastly, in Asia-Pacific, the Chinese economy is expected to maintain a growth rate of mid-single digits over the next few years. Economic growth in India also remains stable despite a strong but a short-term disruption of tax reform. Overall, in Asia, late demand remains stable within the region. And finally, Australia, a key materials producer, is showing moderate growth, in line with the global mining markets. Let's move over to the business overview on Slide 9. Starting with our Light Vehicle Driveline business. Dana has a strong presence in trucks and SUVs where sales remained very solid and vehicle inventories for our key platforms remained low. The Jeep Wrangler launch is proceeding as planned for Dana. Our team is doing a great job now of preparing at the new Toledo facility, which we inaugurated yesterday, but also at 10 other Dana driveline facilities that are producing products such as drive shafts, forgings, castings and, from our recent acquisition, axle components from the former USM plant, now referred to as Dana Warren Michigan. In Thailand, which is a very important country for compact truck manufacturing and export, our operations continue to perform well and demand rate remains strong. Next, the Commercial Vehicle Driveline business continues to see strong demand for specialty and medium-duty trucks in North America. The Class 8 market has realized steady improvement this year, and we expect this trend to carry into 2018. On the commercial front, having recently established new agreements with numerous OEMs, this serves as strong evidence that the investment we have made in technology and our overall focus on the customer is noticed and appreciated. In the off-highway markets, after numerous years of challenging volumes, we are seeing strength in construction markets around the world. This, coupled with steady recovery in the mining markets in North America and Asia, is driving the growth in our off-highway business. The Dana team is doing an outstanding job managing higher demand which, of course, not only meets our own production but also managing the entire supply chain. We are progressing and yielding the benefits expected on the Brevini acquisition, and we expect to achieve our synergy goals as planned next year. Finally, our Power Technologies group has performed very well coming in at more than 15% adjusted EBITDA margin. The team has been managing very significant launch cadence, 60 launches this year, including products on the new Jeep Wrangler, plus the establishment of the new facility in Chongqing, China. Overall, all the groups are operating at a high level with strong support from our functional team members, many of our team markets are reflecting up, and we are excited about our business for the next year. Now I'll turn the presentation over to Jonathan for the review of the financials.

Thank you, Jim. Slide 11 is an overview of the 2017 third quarter and year-to-date financial results. Sales of $1.8 billion were up $447 million versus the same period last year, representing growth of 32%. On a year-to-date basis, sales are up nearly $1 billion compared to the first nine months of last year. As with last quarter, the majority of our growth was organic as we continue to convert our sales backlog and benefit from strong end market demand, ending the third quarter with double-digit organic growth of 21%. Adjusted EBITDA was $216 million for the second quarter, a $48 million increase from the prior year. Year-to-date, adjusted EBITDA was $638 million, up $144 million over last year. Margin in the second quarter was 11.8%, which, on the surface, is 30 basis points lower than last year. But the third quarter of 2016 included gains in a now-divested entity, which I'll cover in a few moments. Margin for the first nine months of this year was a 60 basis point improvement over the comparable period last year. Net income was $69 million, a $12 million improvement over the same period last year. For the first nine months, net income was $60 million better than last year as higher adjusted EBITDA was partially offset by higher depreciation expense due to the increased level of capital spending, higher tax expense due to stronger earnings as well as higher acquisition-related expenses. Diluted adjusted EPS, which excludes the impact of nonrecurring items, was $0.59 per share in the third quarter, an improvement of $0.10 per share compared with last year, and on a year-to-date basis, was up $0.54, driven primarily by higher earnings. Free cash flow of $99 million was $125 million higher than the same period last year, driven by growth in adjusted EBITDA and improved working capital efficiency which more than offset higher capital spending. Please turn with me on Slide 12 for further details regarding the third quarter sales and profit growth. Sales increased by $447 million compared to last year's third quarter, and adjusted EBITDA was higher by $48 million from an 11.8% margin. The year-over-year growth is attributable to four key factors. First, organic growth added $286 million in sales as strong demand for key light and heavy vehicle programs as well as strengthening demand in the off-highway end markets augmented the conversion of our backlog into sales. The organic growth delivered an incremental $37 million of profit. The conversion on this growth was slightly muted by higher plan to launch costs and incentive compensation expense. Second, the business acquisitions made in the first quarter, Brevini and the USM Warren plant added $133 million in sales and $15 million in adjusted EBITDA, which was in line with last quarter. Third, foreign currency was a modest tailwind in the quarter, aiding sales by $28 million and adjusted EBITDA by $3 million due to the relative strength of foreign currencies against the U.S. dollar. Finally, this quarter, the year-over-year adjusted EBITDA comparison was negatively impacted by the $7 million gain recorded last year in our Dana company subsidiary that was divested at the end of 2016. Including the impact of these gains – or excluding impact of these gains, third quarter margin this year was 20 basis points better than last year. Slide 13 provides a more detailed look at our free cash flow generation in the third quarter as well as the first nine months compared to the same periods last year. Higher earnings in the quarter overcame headwinds from the investments we're making to support our growth. The incremental adjusted EBITDA of $48 million, combined with an $80 million benefit in working capital, lower interest and lower income tax outflows, more than offset slightly higher restructuring, transaction costs related to our acquisitions and $14 million of higher capital spending compared to the third quarter of last year. Free cash flow year-to-date improved by $126 million primarily due to higher earnings, lower net interest through our refinancing activities and improved working capital efficiency. These factors were partially offset by higher restructuring, transaction costs, including the settlement of trade obligations related to our USM Warren plant acquisition in the first quarter, as well as higher capital spending this year compared to 2016. Please turn with me now to Slide 14 for a look at our revised full year guidance. As Jim mentioned, conditions across our end markets have improved at a rate higher than we anticipated. Combined with foreign currencies that have strengthened against the U.S. dollar and solid operational execution, this cyclical improvement has provided the basis to increase our guidance as we move into the final quarter of the year. At the midpoint of our revised range, we now expect sales to be about $7.1 billion, a $200 million or 3% increase from the midpoint of our most recent guidance. Adjusted EBITDA is now expected to be approximately $835 million, representing a $30 million increase, and we expect this to result in about an 11.8% margin, which is 10 basis points higher than our prior guidance. Our capital expenditures of approximately $400 million remain unchanged, and we anticipate free cash flow will be about $150 million, up $50 million from our last guide. Finally, diluted adjusted EPS is now expected to be $2.40 per share, which represents an increase of more than 20% over last year. Please turn with me now to Page 15 for a closer look at the drivers of the expected change in our sales and profit versus last year. We now expect sales to grow by $1.3 billion compared with last year and profit to increase by $175 million, which will increase margins by 50 basis points. The same four key factors driving the third quarter results also drive the full year improvements versus prior year. First, organic growth is expected to be about 14% or $800 million, induced by a combination of new business and improved demand in all three of our end markets. This is an increase of about $200 million from our prior guidance with a strong conversion on the incremental sales. Second, inorganic growth, specifically the Brevini and USM Warren plant acquisitions, are now expected to add about $475 million in sales and about $55 million in adjusted EBITDA, representing an improvement over our previous guidance. Third, currency will likely be a modest benefit to sales from translation primarily due to the continued strengthening of the euro against the dollar. However, we expect this will come at a detrimental margin as transaction losses incurred earlier in the year more than offset the conversion on the top line translation increase. Finally, as we’ve communicated all year, we will experience a $15 million headwind in the second half of the year, $7 million of which incurred in the third quarter, with the remaining $8 million expected in the fourth quarter due to the gains last year in our Dana company subsidiary that was divested at the end of 2016. Please turn with me now to Slide 16 to see how we expect the adjusted EBITDA will convert to free cash flow. We expect free cash flow to increase by approximately $90 million over 2016, which is more than 100 basis points when expressed as a percentage of sales in spite of a $25 million use of cash associated with the USM Warren plant acquisition. The $175 million increase in adjusted EBITDA is partially offset by a $75 million increase in capital expenditures to deliver our sales backlog, and these two factors are the primary drivers of the growth in free cash flow over last year. While our full year expectations for capital spending remain unchanged, we now expect that working capital will be essentially flat versus prior year, which represents an improvement over our most recent outlook. The improved working capital and increased adjusted EBITDA are the primary drivers of the $50 million increase in our free cash flow guidance. Please turn with me now to Slide 17 for a look forward to next year. While we’re not providing specific financial guidance at this time, we would like to share our current perspective on our financial performance in 2018 by addressing four determining factors. First, we remain very confident in our $300 million of new business backlog coming online next year. I’d like to remind everyone that the number we publish represent secured, new and incremental business only, net of any business we’ve lost. Holding all other variables such as volume, mix and currency constants, this amount can be added to the current year sales to project mix years outlook. Second, as Jim mentioned earlier, we remain encouraged by the demand indicators in all three of the mobility markets we supply. We believe global light and medium-duty truck volumes will remain reasonably strong; heavy truck volumes in the Americas are likely to improve; and the off-highway segments we supply, construction, agriculture and mining, will continue to steadily improve from the trough levels markets have experienced for the past few years. Third, we expect a modest top line benefit associated with the Brevini and USM Warren plant acquisitions as we will see a full year’s worth of financial results next year versus a partial year this year. We also remain confident in the cost synergy plan for the Brevini acquisition, which we expect will be margin-accretive from this year to next. Finally, we expect foreign currencies will be relatively stable and will not have a material impact as we move into next year. The strong financial results we’ve delivered so far this year as well as our expectations for the remainder of the year combine with these factors to give us confidence that we’re on pace to achieve the long-term financial targets that we provided at our Investor Day nearly a year ago, earlier than we originally expected. I want to thank you for listening in this morning. And I’d now like to turn the call back over to Dennis so we can take your questions.

At this time, we would like to begin the Q&A session. [Operator Instructions] And your first question from the line of Brian Johnson with Barclays. Go ahead.

Yes. Just a couple of questions. Over in the off-highway segment, is there any way to mentioned how much of the year-over-year growth was the prior businesses, end markets expanding in market share, how much were Brevini’s end markets expanding and how much were new synergy – revenue synergies that you’ve realized there?

Hey Brian, this is Jonathan. At this point, the latter two that you referenced are relatively small numbers. The majority of the impact in the growth that we’re seeing within the off-highway segment, that’s market related. It is coming from our traditional markets within the off-highway. So really to a lesser extent, agriculture but primarily, construction and mining, those are the primary drivers. And it’s really the existing business that’s been most of the increase year-over-year.

Okay. And second issue, one of my favorite topics that I discussed with one of your customers, Mr. Marcionni, a couple of days ago. Can you give us your perspective on, a, the changeover from old Wrangler to new Wrangler, how that’s ramping at the Toledo North facility? I assume they have made more than 200 – or they’re on track to make more than 260 in the first month unlike certain next-best OEM. Second, just how long do you think the existing factory is likely to run out the old JK Wrangler platform for export? And then thirdly, he did mention something about a Wrangler pickup truck down the road – if you're going to be involved with that and kind of the timing you're preparing for it.

Good morning, Brian, thanks for joining the call. This is Jim Kamsickas. First, let me start with the changeover. I would say everything, from our standpoint, is on schedule. As you know, in this business, we have different build events that we have to supply to, to get to production vehicles. We're in line with that. I mentioned earlier in the call that we actually opened the Toledo facility and all of our plants are in very good position. So by that, that's all we can speak to relative to the status on the overall Wrangler launch, very, very good situation. How long the old – the next generation Wrangler is going to be produced – still stays in line with what they have been communicating publicly. So we're staying in line with that. And as it relates to the pickup, as you're well aware, we have been on the regular jeeps for 75 years. We'll continue to be in play, I'm sure, with any jeep vehicles with our partner customer, Fiat Chrysler.

Okay, thanks.

Your next question is from the line of Joe Spak with RBC Capital Markets. Please go ahead.

Thanks, good morning and congrats on the quarter. First question, I know – I think it was a couple of – quarter ago in the segment walks you provide – you've got rid of that performance line. But if we look at LVD segment, the sales were very strong. I guess, the incremental margin was a little bit below where it's been in prior quarters. And I'm wondering if that's because you started to incur some of those start-up costs for the Wrangler that you mentioned would be in the back half. If so, if you could quantify that and then how we should think about that into the fourth quarter because it would seem like it might accelerate a little bit.

Yes. So you're right on both accounts. This is Jonathan, Joe. On the first, the Wrangler startup costs in the third quarter have been material. We do expect those to continue ramp up. But the only reason that we're not seeing a stronger conversion within that space is because of the Wrangler startup within the period. A couple of factors – we mentioned, we do have a new facility that we just opened yesterday, as Jim mentioned. So we're carrying a fixed cost for that as we start to install the equipment, do all the builds, as Jim mentioned, and train employees in advance of having any meaningful amount of sellable units that we're shipping. You're also correct that we do expect that to increase as we move in the fourth quarter. So if you look at the overall sales and margin profile based on the guidance we have given, you can see that we expect a bit of margin compression in the fourth quarter compared with the third quarter on a sequential basis. And that's virtually all due to the rampup in the Wrangler cost that we'll incur within the fourth quarter.

All right. So if we didn't have the Wrangler ramp, it looks like on the volume mix flow-through at least in the first half was closer to the mid-teens. So that delta is maybe, like, what, $5 million, $6 million in the quarter. Is that ballpark?

Yes – a little bit more than that, it's probably closer to $10 million.

Okay. And then in off-highway, the data points in the commentary from a lot of the players here seems to continue to get better, right, as it relates to really all the end markets within that off-highway segment. But I guess, what I struggle with sometimes is sort of layering on sort of the recovery with any sort of seasonality that may occur there. So I mean, should we – you've been running sort of this high 300 levels basically in the past two quarters, and it does seem like trends have, if anything, maybe gotten a little better. Is that a reasonable level of sales to assume?

Yes. I think the one thing on the year-over-year comp is that in softer years, because a lot of our production for the global markets comes out of Europe, the month of August can be very soft for us. The reason you saw such a strong period here is there's so much demand that we ended up building through a lot of the third quarter this year and meeting customer demand, where, in the past, we may have utilized that as downtime. So I think you do see – in the year-over-year comps, there's a bit – a little bit of the seasonal impact associated with last year. As far as the run rate goes, I think the best we can do there is just continue to indicate that we see signs that this is still in the early innings of a recovery. And we’re very encouraged by what we see in the customers' build patterns and releases. There's more improvement to come prospectively.

Okay. And just one housekeeping. Can you just remind me, the Dana company impact that you talked about, how does that play out through the segments? Or where does that show up?

It doesn't. So it was not allocated to any of the segments.

So it's just in the corporate line?

You got it. Yes.

Okay, thanks.

Your next question is from the line of Emmanuel Rosner with Guggenheim. Please go ahead.

Hi, good morning everybody.

Good morning.

Hi, Emmanuel.

First question on the commercial vehicle margin. Obviously, the sales growth was very, very robust. I would have maybe expected to the extent that some of these factories may or would not be running full utilization to see maybe better conversion on these sales growth. So I guess, what happened in quarter? But I guess, more importantly, going forward, what is the path towards improving these commercial vehicle margins from the single digit through something that's more comparable to your other businesses?

We'll kind of split that one up a little bit here, Emmanuel. This is Jim. Just I do want to remind you a couple, and I'll let Jonathan get into the numbers. Largely speaking, our margins are improving, but we still have the headwind in Brazil. Brazil, flat to negative depending on mix and everything else. So it really – I can't over accentuate the importance of that. They're all down there, but it's tough, that's for sure. As it relates to kind of on the go-forward, I'll let Jonathan to talk about anything else more specifically on the conversion, is I will say this is a positive market for us, for sure, as we see the day book kind of pretty full – more full than normal at this stage of the year. So that's really a good sign for us leading into next year.

Yes. No, I'd just echo, Emmanuel. There are a couple of factors that have to happen for us to get that vehicle to, or that portion of the business, to double-digit margins. And as Jim mentioned, a more robust build in North America, and that's certainly starting to transpire. But really, a lot of the higher incremental operating leverage we're going to get is when we start to see some modest recovery in Brazil. We have seen a little bit. It's off from a very low base. It all appears to be due to exports at this point. So we continue to look for a pickup in that area, and a modest impact will come at a pretty attractive set of incrementals to help boost the margins of that business.

Okay. That's helpful. And I guess, a question just on your free cash flow and the guidance. So free cash flow guidance was improved by more than the EBITDA guidance. CapEx was sort of maintained at the same level. So what's sort of driving the better – the improvement here? And I guess, when we sort of like look forward, I think part of the free cash flow improvement story here over the next few years was moderation in CapEx. When you think some of these end markets recover faster, some of these revenues coming stronger, does that put some upside pressure on the CapEx needed in the next couple of years?

So to your first question on 2017, of the $15 million increase, above $30 million that was adjusted EBITDA. The balance of the $20 million was essentially working capital. So our working capital efficiency improved. We’ve had some initiatives underway. We got more traction from those than we expected in the third quarter that we expect to flow through on a full year basis. You can certainly see that in the year-over-year comps. But we had originally anticipated working capital would be a modest use of cash. But now it appears that working capital levels are going to remain relatively constant in spite of the fact that we have all of this incremental growth. So we are – we’re encouraged by that. In terms of the longer-term outlook, the profile of our cash flow improvement does still defend on a reduction in capital expenditures. We still remain very confident in that. Last quarter, we mentioned that as we move into next year, we have these major program launches behind us. We expect CapEx to move closer to a replacement level of our new level of depreciation and amortization and we do not believe that the increased volumes that we were seeing now and that we expect to continue into the future will put additional pressure on our capital expenditures. We have the infrastructure to supply our markets at a higher level of volume, in particular in off-highway and in the commercial vehicle space. So we feel comfortable that we still have a very bright outlook of improving free cash flow as we move forward.

That’s very helpful keep it up thanks.

Your next question is from the line of Brian Sponheimer with Gabelli. Please go ahead

Hi good morning

Good morning Brian

Jim, I have a question, more about capital allocation and M&A. Obviously, Brevini, was a very big step in accomplishing which you are wanting to accomplish. I’m curious as to whether from a strategic perspective, you’re seeing a lot of other opportunities that may be similar down this path. And I guess, we can start there.

Thanks for the question, first of all. Kind of – I’d go back to maybe the first time we met. Many of you on the call, the first time we met 2.5 years ago or whatever it was, I used the term white space. And if you just kind of set the table here for a minute. If you look at the four acquisitions we’ve done, one each is falling into each one of our business units because they were pretty natural. Those type of opportunities, they’re always out there in one form or fashion. It’s how much do you need them in terms of fit and filling in the white space. We feel very comfortable with kind of the ancillary pieces that we bolted on for obvious adjacencies that we have. So I would tell you, our focus right now is much more on integrating these – that we did do, opening up the new commercial channels that come with it. Some of them, as you know, come with cross-selling across either the mobility market and industrial mobility, and really focusing on the execution. And we believe, anyway it’s falling through to the bottom line. So right now, I would tell you that’s less of a priority than it was 2.5 years ago when we first met

All right. Secondly, within Power Technologies, clearly, the last six months has seen an increase in headlines regarding vehicle electrification. Regarding your own battery-cooling technology, have you begun to have those conversations follow through with the OEMs? I’m curious as to how much is real versus headline.

Another great question. Thanks. I’ll take that one. I don’t know that there’s an OEM we’re not talking to relative to battery cooling in one form or fashion. Not to overcook it, but as we’ve mentioned in here today, the fact that we’re putting capacity and capital into China, because we got that much demand to go be able to support domestically, is a really good sign. The way I would look at it or suggest that we look at it, for electrification or not comes faster or slower is important, but the reality is hybridization is coming fast. And with that, it’s going to require battery cooling. So therefore, in the sweet spot or near term, there’s a lot of discussion, a lot of actions that we’re taking to support the hybrid play in between over – I would call it over the course of the next 10 years.

Thank you very much.

Thanks Brian

Your next question is from the line of Brian Colley with Stephens Incorporated. Please go ahead.

Hi, good morning and congrats on other strong quarter.

Good morning thanks

So first, I just wanted to ask if you guys could just parse out what specific end markets outperformed your expectations the most from a demand perspective versus where you outperformed from an operation perspective or just on the margin front.

Yes. So I think in the light vehicle space, a couple of our flagship platforms have at a rate higher than we originally expected. We were very bullish on the Super Duty platform that it had done a couple of decades since that had been refreshed. However, we have even been surprised by the sales of that vehicle and the amount of time that customer has had to run or be up in the plants to be able to satisfy the demand. So certainly, that’s the bigger driver across light vehicle. Within the CV market, if you go back to our original expectations, we were in the low 200s from a Class 8 built in North America. We have raised that significantly, and that’s certainly been a driver. Brazil has been a little bit better than we had expected. We’re seeing higher single-digit growth rates compared to what we would have expected in the mid-single-digit growth rate range, off of a very low base. So the sales aren’t significant, but it is notable that outside of Brazil, in that region, we’re seeing increases for demand. So the content we’re supplying is being exported to other markets. Within the off-highway space, certainly, the mining segment. Underground mining, which is where we play has come back at a rate much more rapid than we had expected. On replacement vehicles, we believe, is where the demand is initially. And then also, I would say, to a lesser extent, the construction market has performed at a higher rate than we expected. So broadly speaking, it’s most of the major areas in which we’re operating have been better than what we had called here. In most of those places, it’s substantiated with third party forecast if you go back six, nine months as well to.

Great. That’s really helpful. And then secondly, just given the significant improvement in your free cash flow outlook this year, I just wanted to ask how you’re thinking about capital allocation and what your plans are for the extra cash.

Yes. So our first priority has been to continue to fund the organic growth within the business. So $400 million of capital expenditures is the highest that we’ve seen in this business. So that’s the first place it’s going. We did use an opportunity to have an opportunistic refinancing in the third quarter of this year on our debt. We were able to retire remaining $350 million of bonds with a Term Loan A at $275 million. So some of that cash will go to effectively de-levering and taking advantage of a much lower interest rate in that place. As we look forward to next year, our priorities will remain constant even though capital expenditures should subside. As Jim mentioned, we’ll be focused on looking at these acquisitions, and we’ll continue to be thoughtful about what may be out there. And then we’ll look at what we may need to do to repatriate cash to shareholders as a third-level priority, either in the form of buybacks or potentially something different with our dividends. So we’ll be continuing to look at that, and we’ll communicate more on that as we move forward.

Got it, thanks for time.

Your next question is from the line of Brett Hoselton with KeyBanc. Please go ahead.

Good morning.

Good morning, Brett.

Conceptual question. As we kind of move into this era of more hybrid and electrical vehicles and so on and so forth, I’m thinking about the different potential architectures of the vehicles themselves. And there are some architectures that require an axle, some architectures that combine the axle and the electric motor and other architectures that have, let’s say, the electric motors at the wheel ends and don’t require an axle. And obviously, you’re a big player in this and you have a big vested interest in this. What are you seeing, whether it be on the light vehicle side or the commercial vehicle side, in terms of the direction that the OEMs are taking? Is there a particular favorite methodology that you’re pursuing?

Good question, Brett, and this is Jim. Nice to hear from you. The answer is no one answer. Let me start there. I think that is important that we frame up Dana as it relates your question first. Remember that we’re largely just in the trucks and SUVs. So anything on the passenger car business that we do in the future is all upside to us. Now think about a vehicle from this standpoint. You’re going to have to have the strength, the durability and kind of infrastructure to still carry the loads of a truck and the SUV all the way through our portfolio even into our off-highway products, okay? That’s kind of an important setup, I think. Anyway, so as you move forward, that – what am – I’m talking about when I talk infrastructure, that’s the full axle going across, so on and so forth. There are all those different solutions. But big picture speaking, although we would, especially with the Brevini technology planetary hubs if we wanted to go down the road. Or it seems like it would be the most efficient solution for an OEM, we could do that. That's basically an electric motor hookup to a planetary hub. You drive the four wheels. We do that today, by the way, obviously, an area work platforms, teleboom handlers, all that kind of stuff. Okay, fine. But as it relates to where do they go in the future, it's going to be some – I believe it's going to be some time of axle configuration. We happen to believe that a fully integrated axle with electronics, motors and rotors and so forth is the most efficient by our early days. And that's where we're going with most – like I mentioned earlier on the call, that's where we're going with the bus market in China right now that we will launch by the end of this year. But as – just to speak with examples because I'd like to do that, not any one configuration is always the same. You also notice that electric truck in Great Britain that actually had its prop shaft. So it's driving the power from the front of the vehicle, which is the battery back to the rear vehicle – rear of the vehicle with the prop shaft. That's a lot of words to say there's no one real answer to it. The reality is you have to have solutions to whichever configuration makes sense for the road, makes sense for the market. And I think we're in a really good position to do that because, like I said earlier, is you think about Dana, maybe your first thought is an electric vehicles. But – the reality is we've been doing it for decades, and we've been doing multiple other electronic-like components at Dana for decades. So we're ready to roll.

And as you think about the configuration that you're favoring, let's say, which would be the integrated axle, electric motor. How do I think about that configuration versus the other configurations relative to initial costs but also ongoing costs of maintenance?

Yes, it's great question. I'm not going to be able to quote you numbers specifically on it, but I can certainly paint a visual for you. If you think about the motors on all four of the wheel ends, first of all, the cost of batteries – we all know the cost of batteries. You can extrapolate that. That's going to be expensive. Number two, you think about all the weight associated with doing that, that's expensive, and the packaging is very difficult to do that. So that's where that equation is very difficult. If a customer for whatever reason believes that something they want us to do, we can do that. I'm going to have you do the own math and what you know about battery costs and everything else like that, but that's where it comes back to, will it be much more cost-effective and packaging-effective and efficiency-prospective to be more of an integrated play. That's what we find. And then by the way, if you think about it, not to overcook it, it comes back to my opening comment: You still need that rigidity. You still need that foundation underneath of a truck and SUV, so on and so forth.

Excellent, thank you very much.

You’re welcome. Thank you for the question.

Today's final question will come from the line of Colin Langan with UBS. Please go ahead.

Great, thanks for taking my question. Just a follow-up. I think you've kind of indirectly talked about this. But if I look at your midpoint of your sales guidance for the year, it would actually imply that sequentially, sales would fall from Q3 and normally, seasonality would indicate that Q4 would pick up a bit. Are there any sort of headwinds that we should keep in mind from a sales basis in Q4?

No. Colin, in our case, if you go back a few years, it is typical that the fourth quarter is a bit softer than the second and the third. It's usually more in line with the first quarter. Last year was a bit anomalous because of the launch of the Super Duty, which came on part way for the year and they ran at a normal – abnormal amount of volumes, which made a pretty big impact on our sales with that. So you are right, we do expect it to dip down, but that bell shape – or bell curve-shaped for our sales with a softer first and fourth quarter compared to the second and the third is more normal for our typical seasonality.

Got it. And to circle back on the earlier question on free cash flow, what are the long-term drivers outside of CapEx, what other factors are going to drive higher free cash flow conversion? I think you maybe talked about in the past. Just maybe remind us.

Sure. The primary driver being the growth in our adjusted EBITDA so as we have the backlog come online, we talked about the $300 million we expect next year. As we see market recovery, we expect continual improvement in the conversion margins associated with that. So we're quite excited about the incrementals are coming and that adjusted EBITDA will essentially be cash flow. And then the other piece being the step-down in capital expenditures over that period is expected to be pretty significant associated with getting the two largest programs in the company has now relaunched their refreshes, the Ford Super Duty and the Jeep Wrangler. That's going to be a big driver. And then you have a couple of other factors. We've incurred some costs associated with our strategic acquisitions and the transaction work that we've done. And I'll just remind you, we had that one anomaly this year related to the USM acquisition, which actually sits in free cash flow. That $25 million working capital hit that we took to settle those trade payables, and that became part of Dana, is something that won't recur. So it's not unreasonable to think that under normal environment, you'd see a modest use of cash in working capital as we are growing. But aside from that, all those other factors point us to an increased free cash flow.

And lastly, just a follow-up on Brett's question. In terms of your electronic axle, E-axle position. Can you remind us, do you supply the electric motor in the axle? Or is that a sub-supplier? Just wondering if that's an in-house capability or whether you're outsourcing it and then putting axles together. And then if so, what is the value-added difference between an E-axle and a traditional axle?

So thanks for the question. We do not do motors ourselves. We find it to be more efficient at least for us right now. It seems more efficient to grow that to be a bi-component for us. And really, from a motor standpoint, we could probably stand a call for another hour relative to the different motor configuration, sizes, voltage, et cetera, et cetera. There's no one answer for that as well. So I wish I could give you a better answer there. But at least for us, we're moving forward with a really strong supply base. There's plenty of supply. Let's put it that way. So we're going in that direction.

Got it. Thank you very much.

Thanks, Colin.

Okay. Thank you, everybody, for joining the call. Really, really appreciate it behalf of the entire leadership team here, we're actually very happy with our results. We appreciate your support on it. A lot of companies stir around the term high-performance company. In my view and the team's view here, that's more talking about our results. To get really to the high-performance company, you have to have a high-performance culture that starts with having the right diversity test to deal with having the right safety perspective on safety, having the right perspective on customer focus. And we believe we're doing the right things in that area. And hopefully, we'll continue to – or we will continue to provide those same results because of the built-in process changes we've made, and we'll move forward from here. So thank you very much. Look forward to talking to you soon.

Ladies and gentlemen, thank you for joining Dana Incorporated's third quarter 2017 financial webcast and conference Call. You may now disconnect.