May 5, 2020, 8:14 a.m. EDT

10-Q: ALLISON TRANSMISSION HOLDINGS INC

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(EDGAR Online via COMTEX) -- ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is intended to help the reader understand our business, financial condition, results of operations, liquidity and capital resources. You should read this discussion in conjunction with our condensed consolidated interim financial statements and the related notes contained elsewhere in this Quarterly Report on Form 10-Q.

The statements in this discussion regarding industry trends, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in "Cautionary Note Regarding Forward-Looking Statements" and Part II, Item 1A "Risk Factors" below and in Part I, Item 1A "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2019 as filed with the Securities and Exchange Commission ("SEC") on February 27, 2020. Our actual results may differ materially from those contained in or implied by any forward-looking statements.

Overview

Allison Transmission Holdings, Inc. and its subsidiaries ("Allison," the "Company," "we," "us" or "our") design and manufacture vehicle propulsion solutions, including commercial duty on-highway, off-highway and defense fully automatic transmissions and electric hybrid and fully electric systems. The business was founded in 1915 and has been headquartered in Indianapolis, Indiana since inception. Allison was an operating unit of General Motors Corporation from 1929 until 2007, when Allison once again became a stand-alone company. In March 2012, Allison began trading on the New York Stock Exchange under the symbol "ALSN".

Although approximately 77% of revenues were generated in North America in 2019, we have a global presence by serving customers in Europe, Asia, South America and Africa. We serve customers through an independent network of approximately 1,500 independent distributor and dealer locations worldwide.

Trends Impacting Our Business

Our net sales are driven by commercial vehicle production, which tends to be highly correlated to macroeconomic conditions. In March 2020, the World Health Organization categorized the novel coronavirus ("COVID-19") as a pandemic, and it continues to spread throughout the United States and other major markets in which we operate across the world. To limit the spread of COVID-19, governments have taken various actions including the issuance of stay-at-home orders and social distancing guidelines. While the majority of our plants are continuing to operate as essential businesses, our manufacturing facilities in Hungary, India, Indianapolis and Tennessee have suspended or cut back on operating levels and shifts as a result of government orders, our inability to obtain component parts from suppliers and/or decreased customer demand, and additional suspensions and cutbacks may occur as the impacts from COVID-19 and related responses continue to develop within our global supply chains and customer base. While not material, we began to see the impact to demand in our results of operations during the first quarter 2020 in Europe and Asia as our suppliers and customers reduced or halted production. Additional production slowdowns and shutdowns by our global suppliers and customers have continued during the second quarter of 2020 and the impact on our financial results is expected to be material for the second quarter 2020. We are taking a variety of measures to maintain operations with as minimal impact as possible to our stakeholders and to promote the safety and security of our employees, including increased frequency of cleaning and disinfecting of facilities, social distancing, remote working when possible, travel restrictions and limitations on visitor access to facilities. We are also working to align operations, programs and spending across our entire business with current conditions, including furloughs of a portion of our workforce, freezing all employee requisitions, reducing overtime, and assessing the timing and cadence of various capital investments and product development initiatives.

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The extent to which our operations will be impacted by the outbreak will depend largely on future developments, which are highly uncertain and cannot be accurately predicted, including the emergence of new information concerning the severity of the outbreak and actions by governmental authorities.







        First Quarter Net Sales by End Market (dollars in millions)
                                                          Q1 2020          Q1 2019
        End Market                                       Net Sales        Net Sales        % Variance
        North America On-Highway                        $        352     $        377               (7 )%
        North America Off-Highway                                  8               14              (43 )%
        Defense                                                   40               32               25 %
        Outside North America On-Highway                          72               94              (23 )%
        Outside North America Off-Highway                         27               27                -
        Service Parts, Support Equipment and Other               138              131                5 %
        Total Net Sales                                 $        637     $        675               (6 )%
        


North America On-Highway end market net sales were down 7% for the first quarter 2020 compared to the first quarter 2019, principally driven by lower demand for Rugged Duty Series models.

North America Off-Highway end market net sales were down $6 million for the first quarter 2020 compared to the first quarter 2019, principally driven by lower demand for hydraulic fracturing applications.

Defense end market net sales were up 25% for the first quarter 2020 compared to the first quarter 2019, principally driven by higher Tracked vehicle demand.

Outside North America On-Highway end market net sales were down 23% for the first quarter 2020 compared to the first quarter 2019, principally driven by lower demand in Europe and Asia.

Outside North America Off-Highway end market net sales were flat for the first quarter 2020 compared to the first quarter 2019, principally driven by higher demand in the energy sector, offset by lower demand in the mining and construction sectors.

Service Parts, Support Equipment and Other end market net sales were up 5% for the first quarter 2020 compared to the first quarter 2019, principally driven by aluminum die casting component volume associated with the Walker Die Casting acquisition, partially offset by lower demand for North America Off-Highway service parts.

Key Components of our Results of Operations

Net sales

We generate our net sales primarily from the sale of vehicle propulsion solutions, service and component parts, support equipment, defense kits, engineering services, royalties and extended transmission coverage to a wide array of OEMs, distributors and the U.S. government. Sales are recorded net of provisions for customer allowances and other rebates. Engineering services are recorded as net sales in accordance with the terms of the contract. The associated costs are recorded in cost of sales. We also have royalty agreements with third parties that provide net sales as a result of joint efforts in developing marketable products.

Cost of sales

Our primary components of cost of sales are purchased parts, the overhead expense related to our manufacturing operations and direct labor associated with the manufacture and assembly of transmissions and parts. For the three months ended March 31, 2020, direct material costs were approximately 68%, overhead costs were approximately 23%, and direct labor costs were approximately 9% of total cost of sales. We are subject to changes in our cost of sales caused by movements in underlying commodity prices. We seek to hedge against this risk by using long-term agreements, as appropriate. See Part I, Item 3 "Quantitative and Qualitative Disclosures about Market Risk-Commodity Price Risk" included below.

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Selling, general and administrative

The principal components of our selling, general and administrative expenses are salaries and benefits for our office personnel, advertising and promotional expenses, product warranty expense, expenses relating to certain information technology systems and amortization of our intangibles.

Engineering - research and development

We incur costs in connection with research and development programs that are expected to contribute to future earnings. Such costs are expensed as incurred.

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Non-GAAP Financial Measures

We use Adjusted Earnings before Interest, Taxes, Depreciation, and Amortization ("EBITDA") and Adjusted EBITDA as a percent of net sales to measure our operating profitability. We believe that Adjusted EBITDA and Adjusted EBITDA as a percent of net sales provide management, investors and creditors with useful measures of the operational results of our business and increase the period-to-period comparability of our operating profitability and comparability with other companies. Adjusted EBITDA as a percent of net sales is also used in the calculation of management's incentive compensation program. The most directly comparable U.S. generally accepted accounting principles ("GAAP") measure to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales is Net income and Net income as a percent of net sales, respectively. Adjusted EBITDA is calculated as earnings before interest expense, income tax expense, amortization of intangible assets, depreciation of property, plant and equipment and other adjustments as defined by the Second Amended and Restated Credit Agreement dated as of March 29, 2019 (the "Credit Agreement") governing Allison Transmission, Inc.'s ("ATI"), our wholly-owned subsidiary, term loan facility in the amount of $643 million due March 2026 ("New Term Loan"). Adjusted EBITDA as a percent of net sales is calculated as Adjusted EBITDA divided by net sales.

We use Adjusted free cash flow to evaluate the amount of cash generated by our business that, after the capital investment needed to maintain and grow our business and certain mandatory debt service requirements, can be used for repayment of debt, stockholder distributions and strategic opportunities, including investing in our business. We believe that Adjusted free cash flow enhances the understanding of the cash flows of our business for management, investors and creditors. Adjusted free cash flow is also used in the calculation of management's incentive compensation program. The most directly comparable GAAP measure to Adjusted free cash flow is Net cash provided by operating activities. Adjusted free cash flow is calculated as Net cash provided by operating activities after additions of long-lived assets.

The following is a reconciliation of Net income and Net income as a percent of net sales to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales and a reconciliation of Net cash provided by operating activities to Adjusted free cash flow:







                                                                 Three months ended
                                                                      March 31,
        (unaudited, dollars in millions)                         2020           2019
        Net income (GAAP)                                      $     139       $   167
        plus:
        Income tax expense                                            42            44
        Interest expense, net                                         33            36
        Depreciation of property, plant and equipment                 22            18
        Amortization of intangible assets                             16            22
        Stock-based compensation expense (a)                           3             3
        Unrealized loss (gain) on foreign exchange (b)                 2            (1 )
        Expenses related to long-term debt refinancing (c)             -             1
        Adjusted EBITDA (Non-GAAP)                             $     257       $   290
        Net sales (GAAP)                                       $     637       $   675
        Net income as a percent of net sales (GAAP)                 21.8 %        24.7 %
        Adjusted EBITDA as a percent of net sales (Non-GAAP)        40.3 %        43.0 %
        Net cash provided by operating activities (GAAP)       $     148       $   194
        Deductions to reconcile to Adjusted free cash flow:
        Additions of long-lived assets                               (21 )         (19 )
        Adjusted free cash flow (Non-GAAP)                     $     127       $   175
        


(a) Represents stock-based compensation expense (recorded in Cost of sales, Selling, general and administrative, and Engineering - research and development).

(b) Represents losses (gains) (recorded in Other (expense) income, net) on intercompany financing transactions related to investments in plant assets for our India facility.

(c) Represents expenses (recorded in Other (expense) income, net) related to the refinancing of the prior term loan due 2022 and prior revolving credit facility due 2021 in the first quarter of 2019.

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Results of Operations

Comparison of three months ended March 31, 2020 and 2019

While the recent outbreak of COVID-19 did not have a material adverse effect on our reported results for the first quarter 2020, we are actively monitoring the impact of the global pandemic, which we expect to materially negatively impact our business and results of operations for the second quarter 2020 and likely beyond. See "Trends Impacting our Business" above for additional information on the impact of COVID-19 on our results of operations.

The following table sets forth certain financial information for the three months ended March 31, 2020 and 2019. The following table and discussion should be read in conjunction with the information contained in our condensed consolidated financial statements and the notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q.







                                                                    Three Months Ended March 31,
                                                                          %                               %
        (unaudited, dollars in millions)              2020          of net sales        2019        of net sales
        Net sales                                  $      637                 100 %   $     675               100 %
        Cost of sales                                     311                  49           316                47
        Gross profit                                      326                  51           359                53
        Operating expenses:
        Selling, general and administrative                75                  12            84                12
        Engineering - research and development             36                   6            31                 5
        Total operating expenses                          111                  18           115                17
        Operating income                                  215                  33           244                36
        Interest expense, net                             (33 )                (5 )         (36 )              (5 )
        Other (expense) income, net                        (1 )                 -             3                 -
        Income before income taxes                        181                  28           211                31
        Income tax expense                                (42 )                (6 )         (44 )              (6 )
        Net income                                 $      139                  22 %   $     167                25 %
        


Net sales

Net sales for the quarter ended March 31, 2020 were $637 million compared to $675 million for the quarter ended March 31, 2019, a decrease of 6%. The decrease was principally driven by a $25 million, or 7%, decrease in net sales in the North America On-Highway end market principally driven by lower demand for Rugged Duty Series models, a $22 million, or 23%, decrease in net sales in the Outside North America On-Highway end market principally driven by lower demand in Europe and Asia and a $6 million, or 43%, decrease in net sales in the North America Off-Highway end market principally driven by lower demand for hydraulic fracturing applications, partially offset by an $8 million, or 25%, increase in net sales in the Defense end market principally driven by higher Tracked vehicle demand and a $7 million, or 5%, increase in net sales in the Service Parts, Support Equipment and Other end market principally driven by aluminum die casting component volume associated with the Walker Die Casting acquisition partially offset by lower demand for North America Off-Highway service parts.

Cost of sales

Cost of sales for the quarter ended March 31, 2020 was $311 million compared to $316 million for the quarter ended March 31, 2019, a decrease of 2%. The decrease was principally driven by decreased direct material expense commensurate with decreased net sales and favorable material costs.

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Gross profit

Gross profit for the quarter ended March 31, 2020 was $326 million compared to $359 million for the quarter ended March 31, 2019, a decrease of 9%. The decrease was principally driven by $38 million related to decreased net sales, partially offset by $6 million of lower material costs. Gross profit as a percent of net sales for the three months ended March 31, 2020 decreased 200 basis points compared to the same period in 2019 principally driven by lower net sales and unfavorable mix, partially offset by favorable material costs.

Selling, general and administrative

Selling, general and administrative expenses for the quarter ended March 31, 2020 were $75 million compared to $84 million for the quarter ended March 31, 2019, a decrease of 11%. The decrease was principally driven by $8 million of lower incentive compensation expense and $6 million of lower intangible amortization expense.

Engineering - research and development

Engineering expenses for the quarter ended March 31, 2020 were $36 million compared to $31 million for the quarter ended March 31, 2019, an increase of 16%. The increase was principally driven by the timing of product initiatives spending.

Interest expense, net

Interest expense, net for the quarter ended March 31, 2020 was $33 million compared to $36 million for the quarter ended March 31, 2019, a decrease of 8%. The decrease was principally driven by $5 million of expenses related to the long-term debt refinancing in 2019 that did not recur in 2020.

Other (expense) income, net

Other (expense) income, net for the quarter ended March 31, 2020 was ($1) million compared to $3 million for the quarter ended March 31, 2019. The change was principally driven by $3 million of unfavorable foreign exchange on intercompany financing and $3 million of unfavorable change associated with assets held in a rabbi trust, partially offset by $1 million of expenses related to long-term debt refinancing in 2019 which did not recur in 2020.

Income tax expense

Income tax expense for the three months ended March 31, 2020 was $42 million, resulting in an effective tax rate of 23%, compared to $44 million of income tax expense and an effective tax rate of 21% for the three months ended March 31, 2019. The decrease in income tax expense was principally driven by decreased taxable income.

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Liquidity and Capital Resources

We generate cash primarily from our operations to fund our operating, investing and financing activities. Our principal uses of cash are operating expenses, capital expenditures, working capital needs, debt service, dividends on common stock, stock repurchases and strategic growth initiatives, including acquisitions. Our ability to generate cash in the future and our future uses of cash are subject to general economic, financial, competitive, legislative, regulatory and other factors that may be beyond our control, including the impact to our cash flow that has been experienced, and continues to be experienced, related to COVID-19. We had total available cash and cash equivalents of $114 million and $192 million as of March 31, 2020 and December 31, 2019, respectively. Of the available cash and cash equivalents, $114 million and $122 million were deposited in operating accounts as of March 31, 2020 and December 31, 2019, respectively, while zero and $70 million were invested in U.S. government backed securities as of March 31, 2020 and December 31, 2019, respectively.

As of March 31, 2020, the total of cash and cash equivalents held by foreign subsidiaries was $92 million, the majority of which was located in China and Europe. We manage our worldwide cash requirements considering available funds among the subsidiaries through which we conduct our business and the cost effectiveness with which those funds can be accessed. As a result, we do not currently anticipate any local liquidity restrictions will preclude us from funding our targeted initiatives or operating needs with local resources.

We have not recognized any deferred tax liabilities associated with earnings in foreign subsidiaries, except for our subsidiary located in China, as they are intended to be permanently reinvested and used to support foreign operations or have no associated tax requirements. We have recorded a deferred tax liability of $3 million for the tax liability associated with the remittance of previously taxed income and unremitted earnings for our subsidiary located in China. The U.S. Tax Cuts and Jobs Act requirement of a one-time repatriation tax on foreign earnings and profits resulted in us recording a $6 million liability for the deemed repatriation to be paid to the U.S. Government in 2017. In the future, the U.S. Tax Cuts and Jobs Act provides for tax free repatriations of earnings and profits generated by foreign subsidiaries through a 100% dividends received deduction. The remaining deferred tax liabilities, if recorded, related to unremitted earnings that are indefinitely reinvested are not material.

Our liquidity requirements are significant, primarily due to our debt service requirements. As of March 31, 2020, we had $643 million of indebtedness associated with ATI's New Term Loan, $1,000 million of indebtedness associated with ATI's 5.0% Senior Notes due September 2024 ("5.0% Senior Notes"), $400 million of indebtedness associated with ATI's 4.75% Senior Notes due October 2027 ("4.75% Senior Notes") and $500 million of indebtedness associated with ATI's 5.875% Senior Notes due June 2029 ("5.875% Senior Notes" and, together with the 5.0% Senior Notes and 4.75% Senior Notes, the "Senior Notes"). The minimum required quarterly principal payment on ATI's New Term Loan through its maturity date of March 2026 is $2 million. We made $2 million and zero principal payments on the New Senior Secured Credit Facility during the three months ended March 31, 2020 and March 31, 2019, respectively. There are no required quarterly principal payments on ATI's Senior Notes.

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The New Senior Secured Credit Facility provides for a $600 million New Revolving Credit Facility, net of an allowance for up to $75 million in outstanding letter of credit commitments. Throughout the three months ended March 31, 2020, we made periodic withdrawals and payments on the New Revolving Credit Facility as part of our debt management plans. The maximum amount outstanding at any time during the quarter ended March 31, 2020 was $300 million. As of March 31, 2020, we had $595 million available under the New Revolving Credit Facility, net of $5 million in letters of credit. As of March 31, 2020, we had no amounts outstanding under the New Revolving Credit Facility. If we have commitments outstanding on the New Revolving Credit Facility at the end of a fiscal quarter, the New Senior Secured Credit Facility requires us to maintain a specified maximum first lien net leverage ratio of 5.50x. Additionally, within the terms of the New Senior Secured Credit Facility, a first lien net leverage ratio at or below 4.00x results in the elimination of excess cash flow payments on the New Senior Secured Credit Facility for the applicable year. As of March 31, 2020, our first lien net leverage ratio was 0.50x. The New Senior Secured Credit Facility also provides certain financial incentives based on our first lien net leverage ratio. A first lien net leverage ratio at or below 4.00x and above 3.50x results in a 25 basis point reduction to the applicable margin on the New Revolving Credit Facility. A first lien net leverage ratio at or below 3.50x results in an additional 25 basis point reduction to the applicable margin on the New Revolving Credit Facility. These reductions remain in effect as long as we achieve a first lien net leverage ratio at or below the related threshold.

In addition, the Credit Agreement includes, among other things, customary restrictions (subject to certain exceptions) on our ability to incur certain indebtedness, grant certain liens, make certain investments, engage in acquisitions, consolidations and mergers, declare or pay certain dividends, and repurchase shares of our common stock. The indentures governing the Senior Notes contain negative covenants restricting or limiting our ability to, among other things, incur or guarantee additional indebtedness, incur liens, pay dividends on, redeem or repurchase our capital stock, make certain investments, permit payment or dividend restrictions on certain of our subsidiaries, sell assets, engage in certain transactions with affiliates, and consolidate or merge or sell all or substantially all of our assets. As of March 31, 2020, we are in compliance with all covenants under the New Senior Secured Credit Facility and indentures governing the Senior Notes.

Our credit ratings are reviewed by Moody's Investors Service ("Moody's") and Fitch Ratings ("Fitch"). Moody's rates our corporate credit at 'Ba2', New Term Loan at 'Baa3', 5.0% Senior Notes at 'Ba3', 4.75% Senior Notes at 'Ba3' and 5.875% Senior Notes at 'Ba3'. Fitch rates our corporate credit at 'BB', New Term Loan at 'BB+', 5.0% Senior Notes at 'BB', 4.75% Senior Notes at 'BB' and 5.875% Senior Notes at 'BB'.

On November 14, 2016, our Board of Directors authorized us to repurchase up to $1,000 million of our common stock pursuant to a stock repurchase program (the "Repurchase Program"). On November 8, 2017, July 30, 2018 and May 9, 2019, our Board of Directors increased the authorization by $500 million, $500 million and $1,000 million, respectively, bringing the total amount authorized under the Repurchase Program to $3,000 million. During the three months ended March 31, 2020, we repurchased approximately $180 million of our common stock under the Repurchase Program. All of the repurchase transactions during the three months ended March 31, 2020 were settled in cash during the same period. As of March 31, 2020, we had approximately $872 million available under the Repurchase Program.

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May 05, 2020

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