Dana Incorporated (DAN) Q3 2018 Earnings Report, Transcript and Summary

Good morning and welcome to Dana Incorporated third quarter 2018 financial webcast and conference call. My name is Angela 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, Angela. And good morning to everyone on the call and thank you for joining us for today’s third quarter 2018 earnings call. You will find this morning’s 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. As always, we will end our call with Q&A session. 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 filed 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. With that, I’ll hand the mic over to Jim.

Thank you, Craig. Good morning and thank you for joining us today. I'm pleased to report that, in third quarter, Dana again achieved revenue that was just shy of $2 billion, a 15% increase in sales so far this year. Our adjusted EBITDA for the quarter was $240 million, 11% year-over-year growth, resulting in a 12% margin which is 10 basis points over the last quarter. Net income for the quarter was also very strong at $95 million, a 38% increase over the prior-year. Diluted adjusted EPS increased 31% over last year to $0.77 per share. We are affirming our guidance ranges for the year due to the steady end-market demand and conversion on our sales backlog. Jonathan will provide greater detail on this later in the presentation. Consistent with our strategy, we also remain focused on inorganic growth opportunities highlighted by recent announcement of a definitive agreement to purchase the Drive Systems segment of the Oerlikon Group. Combined with our acquisition of TM4, we are confident that these transactions will deliver significant long-term value by accelerating our commitment to vehicle electrification and strengthening the technology portfolio for each of our end markets. Lastly, we’ll continue to organically grow market share in two ways. First, through immediate takeover of existing business. In the third quarter, we gained commercial vehicle market share which we’ll retain on a go-forward basis by providing exceptional supply performance for our customers in this high demand environment. Second, as I will discuss in a few moments, we were also awarded significant new business through traditional business pursuit activities. Please turn to slide number 5 for Dana market update. One of the strengths of Dana is the balance between our light-duty and heavy-duty markets. Over the past few years, we have seen positive growth in all three of our end markets and we expect all to remain strong next year. In addition to the markets, as we previously communicated, we expect to have about $300 million in additional sales from our new business backlog coming on in 2019. On the left side of the page, we highlight the light vehicle market where growth in North America remains strong for light trucks, driven by continuing shift to SUVs and crossover vehicles as evidenced by entirely new programs such as the Ford Ranger and Bronco. And we see further expansion in emerging markets such as Asia where rising demand for crossover vehicles with all-wheel-drive capability will drive growth. But the light vehicle market is only half of our business. We are very excited about the growth we are seeing in our heavy-duty markets. And In the commercial vehicle segment, the Class 8 market in North America remained stable at a very high level of demand and all indications are that next year will be a very good year for commercial trucks. There is also continued recovery in Brazil where we expect to see positive signs of political and economic stability after this weekend's election. We remain committed to the region and our recent share gains and new product launches will pay dividends as demand improves. We continue to see strong demand in the off-highway end markets, particularly construction and mining in Europe and Asia, and we expect this strength will continue at least through 2019. We have placed a great deal of focus on this market leading to organic growth through market share gains and inorganically through the Brevini and soon to be Oerlikon acquisitions. Bottom line, there has been a lot of noise and discussion recently about declining markets in the mobility space. My message today is that we – that is not what we expect in the core markets as we are on track to continue our growth trajectory next year. On this note, thank you in advance for the opportunity on the next several slides to provide you a few examples of how Dana is accomplishing this growth. Dana's growth over the past three years is largely a result of providing exceptional customer service and product innovation, and we continue this trend. Previously, we shared with you that our industry-leading all-wheel-drive system would be featured on a future global platform. And this morning, I'm pleased to be able to provide you an update on that program. Dana's class-leading Spicer SmartConnect that’s connecting all-wheel-drive system was selected by Ford for the new global Ford Edge program. Starting with the 2019 model year, Dana will be the exclusive worldwide supplier of rear drive units for all versions of the Ford Edge platform in North America, Europe, and Asia. Our best-in-class all-wheel drive system takes advantage of our ultra-efficient Spicer AdvanTEK axle technology, which achieves a substantial 45% reduction in energy loss compared with the typical axle and a 30% improvement when compared with best-in-class competitive products. Our team is especially proud of this cutting-edge technology and their enthusiasm was validated with it recently being named in Automotive News PACE Award finalist for 2019. This is the eighth consecutive year that a Dana technology has been named a finalist. Notably, Dana is one of only five suppliers to be nominated at least eight years in a row. With our North America Ford Edge launch successfully completed, we will leverage this exceptional technology to further penetrate the fast-growing SUV and crossover market, and strengthen our position in this important growth segment, and there is more to come, which we’ll be able to update you on early next year. Moving to slide seven, in the commercial vehicle segment, Dana has signed new long-term agreements with major customers, including, but not limited to, Navistar, PACCAR, and Daimler. Navistar has recently chosen our Spicer Single Drive axles to be standard equipment on their medium-duty trucks and buses, including the international MB Series trucks and CE and RE Series buses. We've also entered into a long-term agreement with PACCAR and are in preferred positioning to provide axles in North America for Kenworth and Peterbilt medium-duty and vocational vehicles. This agreement further solidifies the alignment of PACCAR and Dana as we work together to cultivate solutions that meets the needs of our customers. Lastly, we've expanded our presence in both South America and Europe. In Brazil, we’re excited to be the axle housing supplier for the full line of Daimler heavy-duty trucks and buses. This is in addition to our expanded relationship with Daimler in Europe where we supply multiple driveline products. Moving to slide eight, I'd like to talk about organic growth in our off-highway segment. We also continued to win new conquest business in all of our off-highway segments, especially in the growing construction market. Today, we’re pleased to announce yet another representative conquest business win as we will be providing axles for the next generation soil compactors for Wirtgen who was acquired by John Deere in 2017. These axles will be manufactured in Italy and India. Similar to our communication during previous earnings calls, this win was influenced by leveraging the cross-selling synergies we gained in conjunction with the Brevini acquisition last year. For decades, Dana has been a very strong supplier partner to John Deere, largely on the agriculture side of the business. Brevini was historically strong in the construction segment. This foundation will lead to additional growth opportunities in the construction market as Dana is well-positioned to capitalize on the following. First, market demand for global construction is expected to remain strong, especially in Asia, and Dana will continue to benefit from this market expansion. Second, content per vehicle. For construction vehicles, Dana not only provide traditional powertrain products and systems, but as an extension of our Brevini remaining acquisition in 2017, we also offer planetary hub drives, hydraulics and other motion or application products such as slew drives and winches. The third lever is conquest wins. In addition to the John Deere/Wirtgen, we will provide more granular detail in January, we continue to win conquest new business with numerous construction customers, including JLG [ph], Kubota, Volvo, Manitou, Dynapac, Dingley [ph], SANY and many others. Bottom line, over the past couple of years, Dana has organically and inorganically developed full system capabilities, expanded our product portfolio and strengthened our global manufacturing footprint. Our customers are benefiting. Thus, in turn, Dana is being rewarded through new business awards. Now, let's turn to slide nine. Similar to Brevini, the Oerlikon Drive System acquisition will significantly strengthen off-highway product and systems capabilities. In addition, Oerlikon will further bolster our e-Propulsion portfolio as their electrification competencies and overall know-how is scalable across all of our business units. Having signed a definitive agreement to purchase the Drive System segment of Oerlikon Group since our last earnings call, I'd like to take a moment to update you on the transaction. Oerlikon is a global manufacturer of high precision gears, planetary hub drives for wheeled and tracked vehicles, and products, controls and software that support vehicle electrification across the mobility industry. We are on track to close the deal in early 2019. This transaction will provide Dana significant enhancement in technology, engineering and software development capabilities, as well as an expanded product portfolio, including suburb e-Drive technology for electric and hybrid vehicles in all three of our end markets. It will also increase our capabilities in emerging markets by adding key facilities in Asia, specifically India and China, to serve those growth markets, while also adding core manufacturing capability in the United States for off-highway products, thus balancing and strengthening our manufacturing footprint. The acquisition of Oerlikon will provide Dana significant long-term value by generating synergies and new growth opportunities across all of our end markets, particularly the Off-Highway segment. Turning to slide 10, I’d like to share some exciting things happening with Dana's other acquisition TM4. Since acquiring the majority interest in TM4 in June, as you would likely imagine, the combined team has been incredibly busy integrating motors, inverters, e-gearboxes and thermal management capabilities to develop complete e-Propulsion systems for our customers. The interest across Light Vehicle, Commercial Vehicle and our Off-Highway segments is significant. As displayed in the picture, our team is doing a great job getting out in front of our customers to jointly develop driveline technologies of the future. As you may notice in the upper left-hand corner of the page, we have granted our e-Propulsion systems as Spicer Electrified with TM4. Obviously, both brands have long storied histories that our mobility customers recognize and trust. Our vision for being the leader in efficient power conveyance and energy management solutions enables us to remain energy agnostic, whether it's internal combustion engines today, electric or fuel cell vehicles tomorrow, or something completely unforeseen in the future. As we have stated before, this partnership provides Dana with the capability to provide electrodynamic components, including electric motors and power inverters in-house. It has brought together our leading mechanical, power conveyance and thermal management technologies with TM4’s experience in electric motors and inverters to offer a full range of hybrid and electric vehicle solutions for all drive configurations across all three of our end markets. Turning to slide 11, I appreciate that you have provided me this opportunity to illustrate Dana's full capability of electric vehicle solutions when displaying the combined products from Oerlikon and TM4, along with Dana’s previously existing e-gearbox and thermal portfolio, resulting in a full range of solutions to the complete vehicle spectrum. The message is clear. Dana is the only supplier with full e-Propulsion design, engineering and manufacturing capabilities, allowing us to provide our customers with a complete range of products that covers all powertrains and vehicle classes. The combination of Oerlikon’s e-Propulsion portfolio technologies, along with Dana's TM4’s product solutions, will continue to serve as the enabler for Dana to lead the evolution of power conveyance and support our customers across mobility industries. Our customers see tremendous value by complementing 20 years of TM4’s traction motor experience with Dana's 100 years of axle and thermal management expertise. They are very excited to work together with us to integrate the best solutions into future mobility. As we turn to slide 12, you will find an additional illustration where we’re partnering with our customers along this electrification journey. As more and more OEMs announce the movement to electric fleets to meet stricter environmental regulations and growing demand for greater efficiency, Dana is capitalizing on these new opportunities in this important sector. Last month, at IAA Commercial Vehicles in Europe, DAF, a PACCAR brand, rolled out its fleet of plug in, all electric trucks, including all new DAF LF Electric, a medium-duty distribution truck featuring Dana's TM4 SUMO motor and electrodynamic components. The medium-duty truck market is a key growth area for vehicle electrification, especially in city delivery applications with defined routes and ranges, but that is just the beginning. Moving to slide 13, as urban areas continue to expand and pollution concerns grow, electric buses are also becoming more common. Many heavily populated cities around the world have made commitments to purchase additional electric buses or to switch their entire fleets over the upcoming years. But it goes beyond just transit buses. Regulators are also considering school buses. With more than 0.5 million school bus buses operating in the US alone, some estimates state that 25 million children collectively ride approximately 62 billion miles a year in school buses. Many of these use diesel engines which have been shown in some studies to cause cancer and other negative health effects. These markets are providing significant opportunities for Dana. Here in the United States, it's quite possible that your child may already be riding an all electric school bus powered by Dana's e-Propulsion system, such as the one currently featured on the Lion Type C, an all-electric school bus. The Lion C features a complete Dana drive system, including the TM4 SUMO motor, coupled with Dana's axles and driveshaft, establishing the first all-electric model in production in North America. Lion already has hundreds of vehicles on the road and have logged more than 2 million miles thus far. As you can see, the recent acquisition of TM4 has already proven to be a game-changer for us. As globalization, increased environmental concerns, and the need to reduce operating costs continue to drive customer demand, our scope of product offerings for electric vehicle is very attractive to our customers. And next year, after we complete the Oerlikon transaction, Dana's full range of e-Mobility solutions will further strengthen our position as a leading technology provider in this fast-growing market. Now, I’ll turn the presentation over to Jonathan for the review of the financials.

Thank you, Jim. Slide 15 provides a financial overview of the third quarter and first nine months of 2018 compared with the same periods last year. For the third quarter, sales reached $1.98 billion, an increase of $147 million compared to the same period last year for a growth rate of 8%, primarily from the conversion of our backlog and strong market demand propelling us to nearly $800 million in sales growth so far this year. Adjusted EBITDA for the quarter was $240 million, a $24 million increase from the prior year for a profit margin of 12.1%, which is 30 basis point improvement over last year's third quarter and a 10-basis point improvement over the second quarter of this year. The margin result is slightly below our expectations due to higher raw material cost for which I'll provide more color on the next slide. So far this year, we’ve generated nearly $100 million more of adjusted EBITDA, a 15% increase. Results for net income and diluted adjusted EPS were both higher in the third quarter with net income of $95 million, a $26 million year-over-year improvement, and adjusted EPS of $0.77, an $0.18 per share improvement over last year's third quarter. Free cash flow is $34 million in the quarter, $65 million lower than last year as higher working capital offset the benefit of higher adjusted EBITDA. Please turn with me to slide 16 for further details regarding the third quarter sales and profit growth. Third quarter sales and adjusted EBITDA growth over the prior year of $147 million and $24 million respectively is attributable to four key factors. First, organic growth added $168 million in sales as we continue to convert our backlog and demand in our end markets remain strong. The organic growth delivered an incremental $38 million of profit for a conversion of more than 20%. The sequential improvement in the conversion rate is primarily due to the dissipation of Jeep Wrangler launch cost, including the first half of this year, as well as the fact that we have broken out the discrete impact of commodity cost increases, net of recoveries, to provide a bit more insight into the effect this is having on our profit margin. Second, inorganic growth continues to drive margin expansion as cost synergies related to last year's Brevini acquisition are realized. Third, foreign currency was a modest headwind in the quarter, lowering sales by $42 million and adjusted EBITDA by $4 million due to translation of international results at currency rates, primarily in Latin American countries, that weakened against the US dollar, although the impact to margin is relatively small. Fourth, the scale of the commodity cost increases had a significant impact on our margins in the quarter. As we’ve consistently communicated, we recover the majority of these increases from our customers, but typically on a one to three-month lag. Raw material prices increased cost by $37 million over the same period last year. However, we recovered $21 million in the form of higher selling prices. The net impact reduced third-quarter profit by $16 million, lowering margins by approximately 100 basis points. Needless to say, we remain encouraged that we were able to continue to deliver profitable growth and expand our margins in spite of a higher commodity cost. Please turn with me to slide 17 for a closer look at the free cash flow profile at this point in the year. We generated $34 million of free cash flow in the third quarter compared to nearly $100 million last year as our profit growth was more than offset by higher cash taxes and seasonal working capital requirements to deliver the sales growth based on our customers’ build patterns. Elevated cash taxes were the result of timing of payments and increased income in taxing jurisdictions. Working capital has been a significant use of cash for the first nine months of the year. This pattern is not unusual for us during periods of significant sales growth and reflects a conscious choice on our part to carry more inventory to assure uninterrupted supply for our customers and maximize our own operating efficiency. We do expect to generate a significant amount of cash in the fourth quarter as our inventory and receivable balances fall as they typically do during this time of year. So far this year, capital expenditures remain below the prior year and we expect them to be significantly below the prior year during the fourth quarter as we had elevated spending last year related to the Jeep Wrangler launch. Please turn with me now to slide 18 for an overview of commodity costs and how they're affecting our business. Like other mobility parts suppliers, we’ve experienced significant commodity price inflation this year. These increases are being driven by higher demand and, to a lesser extent, the indirect impact of global trade disputes. Steel, specialty steel such as SBQ, and aluminum are the key commodities in the majority of the parts we produce. We primarily purchase intermediate materials, such as forgings, casting tubes and bar stock, made from these base commodities. Please note the charge towards the center of the slide. They illustrate how the price movements in the base metals, represented by the red line, have preceded the price movements in the intermediate goods that we purchase, represented by the blue line. The largest impact we've experienced this from steel. The steel index has increased by nearly 50% compared with last year. Well into the third quarter, we experienced rapid price increases in the intermediate purchase goods made from steel. Specialty steel costs have increased, but due to the nature of our contracts the majority of the impact occurred earlier in the year. Aluminum costs have risen by more than 20% and these increases have had a significant impact on the second half of the year. In the aggregate, we expect the gross commodity cost impact, before any recovery from our customers, to be more than $100 million this year. Please turn with me now to slide 19 for a closer look at how these commodity cost increases, as well as the corresponding recovery we receive, impact our full-year sales and profit growth. Our full-year sales and profit expectations remain within the prior guidance ranges we provided. However, the commodity cost increases I just discussed put our adjusted EBITDA expectations below the midpoint of our range and also have an impact on our implied profit and free cash flow margin guidance, which I’ll provide on the next page. As we did with the third quarter year-over-year growth chart, we’ve isolated the commodity impact separately as the same four key factors are driving our full-year results. First, organic growth remains the primary driver of both our sales and profit projections for the year, with continued strong demand and backlog contributions expected to generate $725 million in organic growth this year, with a nearly 20% conversion. Second, inorganic growth remains on track to provide a meaningful contribution to our margin expansion, primarily due to the benefit of the cost synergies associated with the Brevini acquisition. Third, we now expect the impact of foreign currency to be relatively flat compared with last year versus the modest tailwind we had previously forecasted. Fourth, as we now discussed in detail on the prior page, we expect a total cost impact of $105 million from commodity inflation, with a recovery of about $65 million this year for a net profit headwind of about $40 million. This results in a 70-basis point adverse impact to our profit margin. Please turn with me to slide 20 for a summary of our full-year financial guidance. We are affirming our full-year financial guidance ranges from July. We continue to expect sales at the high-end of our range, approaching $8.1 billion which would result in double-digit growth over last year. Due entirely to the changes in commodity cost, net of recoveries, we now expect adjusted EBITDA to be closer to $965 million, implying a 12% margin. This also represents double-digit growth over last year and a 40-basis point expansion of our profit margin for the third year in a row. Due to a combination of a slightly lower adjusted EBITDA as well as our latest expectations for working capital requirements in the fourth quarter, our implied free cash flow margin is likely to be closer to 3% than the 3.5% we last expected. Our diluted adjusted EPS range remains unchanged and we expect it near the midpoint of the range at $2.90 per share. Please turn with me now to slide 21 for more detail on how we expect profit will convert to free cash flow. We expect to convert 60% of our profit growth to free cash flow growth. At $240 million, $80 million higher than last year, our implied free cash flow margin guidance represents 80 basis points of expansion over the prior year. In addition to the $130 million increase in adjusted EBITDA, we do expect one-time cost and interest expense to be lower than last year. Cash taxes will be in line with our previous indication, which is an increase of $55 million over last year due to the higher concentration of earnings in tax paying jurisdictions, as well as a restructuring we completed earlier this year that will provide future benefits. Now that we have better line of sight into our production schedules through the end of the year, we expect working capital to be a slightly higher use this year to support our sales growth. As we've indicated all year, the year-over-year increase in working capital also reflects the payment of incentive compensation that was earned last year. Finally, capital spending will subside from last year's peak level of approximately 5.5% of sales as we expect it to be about 4% because we've completed the majority of our investment to support our new business growth. As we move into the final months of the year, we want to provide you a summary of our sentiment on the business. The major contributors are outlined in the four quadrants on slide 22. The top two represent our perspectives on topline growth. As Jim outlined, we continue to be very encouraged by the sales outlook for our business. On the left, we highlight the strength of our markets and our consistent outperformance to the overall trends. In our view, it's important to remember that we have $300 million of backlog coming online next year across all three segments. On the right, we reflect on the impact recent inorganic actions will have by positioning our product portfolio to capitalize on the electromobility trend via TM4 and the growth we will see as we expect to close the Oerlikon Drive Systems transaction early next year. The bottom quadrants reflect the macroeconomic headwinds we expect to continue to experience as, on the left, demand for commodities escalate in an environment of global trade disputes and, on the right, we see impact from the strengthening of the US dollar against foreign currencies. We continued to manage both of these issues through commercial recoveries as well as natural and synthetic risk mitigants. On balance, we continue to expect solid top and bottom line growth along with meaningful profit and free cash flow margin expansion moving into next year as we continue to closing in on our long-term financial targets. I’d like to thank everyone for listening in this morning and I'll now turn the call back over to Angela, so that we can take your questions.

[Operator Instructions]. Your first question is from Brian Johnson with Barclays.

Yes. Good morning. I want to talk a little bit – a couple of things. First, on the Edge program you announced, part of the reason the CapEx went up and cash flow went down was the big Toledo plant that you're doing. Is that a program that is going to be produced at that plant or could you remind us of some of the other things coming online in that plant that will accommodate growth without additional CapEx, significant additional CapEx.

Good morning, Brian. This is Jim. Thanks for the question. A couple of things. First of all, that program for the all-wheel-drive disconnecting will be produced in our Columbia, Missouri facility, as well as this facility in China that we’re building right now, which is in Chongqing. Relative to Toledo specific, that plant, as you're well aware, is doing the Wrangler program. It’s done a great job launching that program and it's right on the front end now of the Ranger launch as well as the Bronco after that and perhaps another vehicle after that. So, that's kind of the big capital items, it relates to that. The only other thing I would remind you of the collective group is we’re also building a gear plant in Hungary right now, which will support that market for high-end precision gearing.

Okay. The subtext is then just how should we be thinking then about CapEx over the next couple of years.

Yeah. Brian, we continue to believe that CapEx going forward will be pretty close to 4% of sales on an annual basis that’s closer to our normalized replacement level. Once we've gotten past, as you noted, the major launch of the Jeep Wrangler, as well as the year before that, the long-due refresh of the super-duty program, the combination of those are what drove us into that mid 5% range for a couple of years.

Okay. Second set of questions is around power tech. Power tech margins have been at least below our models for two quarters in a row. When you go through all the commodity pressures, are those for whatever reason particularly concentrated in powertrain? I know you and your prior management and all the way back to John Devine spent a lot of time on the driveline units making sure that there was recoveries on commodities. Is power tech not in that same place or is there something different than commodities going on in power tech?

No, you're onto it, Brian. It's primarily commodity. So, when we’ve talked about our blended recovery, we do focus on the driveline business, but we also do include power tech. As you would imagine, there are different ranges of recoveries across our business. For example, our Off-Highway segment has the highest recovery rates of any of our business and power technologies has the lowest. The combination of their overall recovery rates being the lowest and the fact that aluminum is up substantially has had an impact on them in the past couple of quarters. We’ll continue to look at opportunities to improve that, other ways to recover going forward. We do think that business does remain positioned for profitable growth as engines become more efficient. We’re seeing higher content in both the ceiling and the thermal solutions. But, in the near term, some of the margin pressure we have experienced is related to commodities and specifically aluminum.

Okay, thanks.

Thank you.

Your next question is from Aileen Smith with Bank of America Merrill Lynch.

Good morning. Thanks for taking the question. The --

Good morning, Aileen.

The $40 million hit on adjusted EBITDA from commodities despite the $65 million in recovery that you're getting from your customers, is this your customers pushing more of the raw material cost burden back to you at all? And as you look forward into 2019, do you have any high-level for expectations for commodity costs and how they work into your P&L and how do you get comfortable if at all that commodity headwinds are not going to intensify further?

Yeah. So, to the first part of your question, the recovery ratio is not a reflection of the economic burden being pushed more towards us. The reason that we’re calling it out discreetly now is just because, now that we've hit over $100 million, the impact from a margin perspective is substantial. So, that recovery ratio is a little bit lower than our stated rate, largely because of the lag impact. As they continue to rise, we just don't get caught up until they plateau. So, that's why we’re a little lower than the 70% range that we have talked about. As we think about next year, we did try to intone that we think commodity cost will go up next year. From an intensity perspective, it's probably a bit early for us to call that, but we do think that cost will go up. We do expect to be able to continue to recover at these ratios and we think that it is going to be a headwind moving into next year. But as we noted, we've got a number of other things moving in our direction on the organic and inorganic growth basis, which is giving us confidence that we’re going to be able to continue to grow the business profitably and expand margins moving into next year.

Okay, great. And just as a follow-up to that, looking at slide 19 on the revenue and EBITDA walk relative to your 2Q 2018 slide deck, is the difference on the implied conversion of 19% in this slide deck relative to 15% in the last one, just a function of you breaking out explicitly now the impact of commodities or is there implicitly an assumption for improved conversion relative to your prior expectation?

No, it's primarily the former. So, previously, the impact of our commodities hadn't gotten to the point where we felt it was necessary to break it out discreetly, but the primary driver in the change is that – when you think about it from how that compares to the first half of the year, I did also mention that it has something to do with the launch efficiencies associated with the Wrangler, improving as we move throughout the year, but from a Q2 to Q3 comparison perspective, that's the primary driver.

Great. And last question, and I realize it’s early to give explicit guidance on 2019, but given the recent volatility from a macro perspective and specifically revisions from third-party sources on production expectations, can you remind us some of the industry data sources you are looking at to gauge future demand or strengthen your end markets? Are you looking at ISM or other economic indicators? Is it your customers’ backlogs or really just what you're seeing in terms of quoting and production on your key programs?

We’re typically looking at the same external guidance or external research that you look at as well. For example, we look at IHS for our light vehicle business, we look at ACT for our heavy commercial vehicle business. It’s a combination of looking at those as well as getting feedback from our customers as you note to get a sense of where we’ll be next year. I think some of the things we’re intoning, there’s relative consistency that we think it's going to be another strong year within the Class 8 market in North America, for example. Most sources look at medium-duty being strong next year. We continue to see calls for growth in the construction and mining segments as we move into next year in most places around the world. And then, as we look at light vehicle, again, remember, we’re focused largely on the truck segment and we continue to think that trucks will be stable next year. So, it’s a combination of those sources that are giving us the sense – the only factor that’s unique and internal to us is our backlog. So, our backlog, we have a buildup at a detailed program level of the incremental content in businesses that we've conquested to give us the confidence in that $300 million of growth next year.

Great, thank you. That’s very helpful.

Yep.

Your next question is from Joseph Spak with RBC Capital.

Thanks. Good morning, everyone.

Good morning, Joe.

Just turning the page a little bit to the lower free cash flow, it sounds like it's mostly from some of the lower EBITDA and that you're still sort of counting on this big working capital benefit in the fourth quarter. Is that the correct interpretation?

Yup. So, it's two factors. It’s being closer to the $965 million versus the $980 million. It’s about $15 million of it. And then, as you noted, when we have pretty good line in the sight of what inventory we’re going to have to have through the last 90 days, it will be a little bit higher than we expected. But as you'll know, we plan to generate all of our free cash flow in the fourth quarter, which is pretty normal in a year of growth that it happens in the second half of the year. It's just more acute to the fourth quarter based on what our customers build patterns were in the third quarter.

And then, you mentioned sort of progress towards your sort of longer-term targets. You've had this 5% free cash flow to sales target for 2019. Any sort of revised thoughts on that, especially you've maybe got a little bit of a deeper dive on Oerlikon and whether that impacts that ratio at all?

Yeah. So, when we think about our long-term financial guidance, I’ll first say that we do remain very confident that we will be able to get to 12.8% margin than a 5% free cash flow. The impact that we've seen on commodities in the second half of this year does put a little bit of question into the timing of getting there, but we are convicted that we’ll be able to get there. It’s just going to be an issue of the timing it takes based on commodities. And when I refer to those two numbers, I'm certainly referring to it on a pre-Oerlikon basis. Certainly, Oerlikon will have an impact more on free cash flow in its first year because of the fact that we will be making investments to achieve those cost synergies. But on the core business ex-Oerlikon, that's where I'm doing the comparison to the targets. And certainly, when we come out with our full-year guidance in 2019, early 2019, we’ll give a very clear view of what both of those pieces look like.

That's very helpful. And then, just lastly for me, as we've gone through earnings season here, we’ve been hearing, even some sort of companies maybe then reporting on the off-highway side some inventories building up. Are you seeing any of that? Or like, how would you sort of classify the channel on the off-highway side?

I would see our core segments, particularly construction as mining, the demand from an order perspective remains strong. The line of sight in communication that we have with our customers into what's driving that is continually their need to fill orders for their end customers. So, we are not seeing it in some of the areas that – in the most significant areas for us. And that's part of what affects our outlook moving into next year. We continue to expect pretty strong demand in our core segments.

Thanks.

Sure.

Your next question is from Rod Lache with Wolfe Research.

Good morning, everybody.

Good morning, Rod.

Wanted to ask, the new business that you talked about at the start of your prepared remarks, can you comment a bit on the timing? And it sounded like – I think you had mentioned some takeover business. So, does that affect the $300 million backlog that you have for next year? And any other color that you can provide? It sounds like it's spreading beyond just the light vehicle business into some of the other segments.

Thanks for the question, Rod. This is Jim. Just some color around that. Yes, I think everybody's quite aware of there is – especially in off-highway and commercial vehicle – a supply shortage and all sorts of things out there going on. We made a very, I’d call it, manufacturing strategy specific call back, I don't know, maybe a year ago even, about carrying some higher inventories, having the right capacity in place. We didn't need to repeat any history that people have dealt with and when you have these high spikes over the course of these cyclical markets. So, ultimately, we positioned ourselves really, really well. And fortunately, our customers have moved share. And you know how it works, particularly in commercial vehicle, to make sure protect supply and make sure that they can protect their customer. They moved quite a bit of share to us across multiple customers, and many of them with long-term commitments for go-forward basis. So, I don't really want to get into all the details other than to use a matter of example that we announce the medium duty standard position on Navistar as a surrogate example, but that's exactly what happened. And we’re seeing some of that to a less material perspective, but we see some of that in the off-highway segments as well. So, it is takeover, but it retains for years to come.

So, there's upside, in other words, to the $300 million? Is that fair?

Absolutely. Absolutely.

And could you just remind us of the performance of South America? I believe that you've said before that, even at sort of the trough of the market, that business has been kind of at breakeven. The real is appreciating now. There's a little bit more optimism about that region. Can you just speak to what the opportunity is for that in commercial vehicles?

Yep. We continue to see improvements within that segment for us. Demand has continued to move up. We are at a point that the operation has made money for us where, in the past, it has been closer to breakeven. So, we’re really encouraged by that. We’re also looking to the outcome of the political elections, in hopes to provide some stability and continued traction from an economic perspective. We've always pointed to the fact that that has the opportunity to have very strong conversion rates for us. So, as we look into next year, we’ll be very thoughtful about the opportunity that’s coming there to help potentially offset some of these other headwinds, like commodities, for example.

Great, thank you.

Sure.

Your next question is from Colin Langan with UBS.

Oh, great. Thanks for taking my question. [indiscernible] has been, I think, 15%. The guidance for Q4, unless I'm absolutely wrong, I think it’s only about 2% year-over-year. Can you just remind us of what are the key drivers of why the growth rate would suddenly crack so much downward?

Yeah. We saw a pretty good growth on a year-over-year basis Q4 of last year. It is going to be our smallest quarter from a sales perspective, which is normal due to the seasonal build patterns that our customers have. And we’re at the high-end of the guidance range. The market could be a little bit better. And then, the other factor you have to look at is FX. So, FX, we’re expecting it to be a bit of a headwind in the fourth quarter. So, the constant currency growth rate would be a bit higher than the 2% to 3% that you just mentioned. So, I would say it’s a combination of those factors.

Got it. And in terms of commodity costs, you highlighted steel. Can you remind us what the key grades of steel because steel has been up since the beginning of the year, so it’s surprising now? So, is it exposure that you have in particular to certain grades that suddenly spiked or any color there why this wasn't a bit more anticipated given the deal was up earlier?

Yeah. It has been up, but we saw it move up even more in the second half of the year. We try to illustrate the steel index that we used on the commodity page by the redline. And then, you do see a bit of a lag in the impact for us, but I would note that SBQ is a specialty steel that we called out as a separate category that is somewhat unique to us. Its movement has been up pretty significantly for us and we see an impact there as well too. So, I would say it’s a combination of both of those that are causing the impact.

Got it. And then, just lastly, tax guidance seems to have been brought down a bit and implies much lower rate in the second half. Why the improved tax guidance and how should we think about tax going forward more importantly?

Yeah. The only significant driver in our tax rate is just jurisdictional mix and the effective rates of where we’re incurring our profits. From a cash tax perspective, the third quarter has always been relatively high for us and our profit growth has been in regions where you would see tax payments being made in the third quarter normally. So, on balance, our full-year EPS reflects the expected tax rate based on where we see our jurisdictional mix.

And so, nothing has changed to the long-term tax outlook that we should be modeling in?

No, I think it would be pretty consistent.

Okay, all right. Thank you.

Sure.

And your last question is from Brian Colley with Stephens.

Hey. Good morning, guys.

Good morning, Brian.

So, given you've been pretty acquisitive over the past couple of years, I want to get your updated thoughts about the likelihood of additional deals going forward? Is it reasonable to expect you take a pause and digest some of the recent deals or is that not the case?

As we've mentioned before, we’re constantly looking for opportunities to augment our competitive position through a better footprint and better product technology. So, M&A has been a tool to do that. I would say, given the recent TM4 acquisition and the Oerlikon acquisition, we’re very focused in the near term making sure that the we’re prepared to integrate Oerlikon when that deal closes, which we expect would be early next year. We've been heavily focused on the integration activities with TM4 and some of that was evidenced in some of the slides that Jim walked through during the prepared remarks. We’re seeing that technology on road and we have a full suite of electric propulsion products available for all vehicle architectures. So, I would say our near-term energy has been heavily focused on integrating the deals that we've been able to sign up and are in the process of closing, but we are always looking for places to augment. We’ll continue to be disciplined from a pricing perspective and look for things that have a right fit and always keep our balance sheet in a strong position.

Further qualifying your point on it, to what Jonathan just said, from one thing you can you can certainly tell from us up to this point and for the future, we don't get the deal fever. Our acquisitions have been accretive. They’ll continue to be. And as I did mention on the last earnings call, there was a little bit of a gap, particularly software and controls. It’s one thing to have different product portfolio. It’s another thing to make sure that you can pull them together. And certainly, with Oerlikon, that's been a nice piece and it will continue to be a nice piece in the future. So, thanks for the question.

Got it. Thanks. And then, lastly, just wanted if you guys have any updated thoughts on buybacks going forward. Just wondering if maybe you guys have thought about getting more aggressive on that front, given the pull back in the stock.

Sure. That’s something that we constantly continue to look at. We had bought back some stock earlier this year. Certainly, we believe it's a good value, given some of the commitments we've made from an inorganic perspective and the commitment to the quality of our balance sheet, we’ll continue to monitor it, but there's been no significant change in our view there per se. We do have the authorization to buy back more. We’re operating under a $200 million authorization for this year and next, but we’ll continue to keep an eye on it. But no major change from our perspective at this time.

Great. Well, I appreciate the time.

Sure, thanks.

Okay. With that, thank you, everybody, for joining the call. I would just recap this one to take a second. Very proud of our team, in particular. We successfully completed the Wrangler JL launch. It's our largest and most complex program in the company. Team, well done. Thank you very much. As I mentioned a little bit earlier and in kind of addition to that, we've launched the first leg of the all-wheel drive. Exciting product that should go across the market. From my standpoint, our standpoint, we have strong demand in all of our markets, not just now, but on a go-forward basis. And at the same time, we’re performing in that market as our customers are continuing to make conscious decisions to elect and select Dana for their new business. We have a track record of acquiring and integrating companies. We’re really excited about Oerlikon coming on, starting at the beginning of next year, which positions the company not only for today, but the future. Very, very important. Thank you very much for joining the call.

This concludes our webcast and conference call. You may now disconnect.