Navistar's Turnaround Progress Overshadowed by Warranty Problems

While Navistar has made substantial progress in its Drive to Deliver turnaround program, it still reported worse financial results for its fourth fiscal quarter than it had aimed for. Executives said the main culprits were industry truck sales levels that didn't pick up as soon as expected, and the continuing high warranty costs for its legacy all-EGR EPA-2010 engines.

Navistar reported a net loss of $154 million, or $1.91 per diluted share, on revenues of $2.8 billion. That compares to year-ago Q4 losses of $2.8 billion, or $40.13 per diluted share, on $3.2 billion.

However, while the numbers are vastly improved over a year ago, they were still lower than the company had hoped.

Revenue was down 13% over the year before. The results reflect lower sales across all business segments, primarily due to weaker industry conditions and lower market share during the company's emissions strategy transition.

"It took us longer to get traction in Class 8 product than planned," said Troy Clarke, Navistar's president and chief executive officer, in a conference call with investors Friday morning. However, he emphasized positive achievements.

"Navistar is a much better company today than we were a year ago," Clarke said.

"We rebuilt our senior leadership team, meet or beat product launch dates regarding emissions change, received 13 liter Maxxforce with SCR engine approval from the EPA, and in that process repaired our relationship with that agency," Clarke said. In Class 8, Navistar completed its switch to engines using selective catalytic reduction during the quarter, with the International Lonestar getting the Cummins ISX.

The company reduced its structural costs by $94 million in the quarter compared to fourth quarter 2012, and finished the full year with reduced structural costs of $330 million versus 2012.

Navistar achieved its fourth quarter cash guidance, finishing the quarter with approximately $1.52 billion in manufacturing cash and marketable securities – the highest it's been in at least 30 years.

"Operationally, we hit our plan this quarter, and we ended the year with an order backlog that is up 26% compared to this time last year," Clarke said. "Those are just two examples of the continued progress we are making on our Drive to Deliver turnaround plan."

Warranty headaches

If you could somehow not count the warranty adjustments for the all-EGR engines and asset impairment charges, Navistar's EBITDA would have been positive.

"The topic has been a cloud over the financial results of the company, and we need to get our arms around it -- we will get our arms around it," said Walter Borst, executive vice president and CFO. "It is overshadowing the signifcant achievements taking place in other parts of the business."

The company has been putting additional resources into understand the warranty problems, both how to fix the engines and how to better predict its warranty exposure.

The company says it's now halfway through its exposure on the all-EGR engines. Most of them will be out of warranty by the end of 2015.

The company's goal is to lower warranty to 2 to 2.5 % of revenue, which is industry norm. It was near that back in 2010, but by 2012 it shot up as high as 7%. Company execs said they are headed in the right direction.

Clarke emphasized that in the transition to the SCR product, the company has been releasing products only after stringent quality testing. "Which means we're not adding to the [warranty] issues, and early results show significant quality and fuel economy improvements."

Jack Allen, executive vice president and COO, made the same point. "The good news is that we are not seeing these issues with our new SCR engines. We believe the high levels of initial quality we're seeing will equate to higher levels of quality throughout their life cycles and the warranty spend will reflect industry norms."

Medium-duty

After Navistar made the announcement in 2012 that it would switch its heavy-duty trucks over to SCR technology, it suffered a big and unanticipated hit on the medium-duty side. Truck buyers apparently decided they would wait until Navistar did the same thing for the midrange engines. So Navistar decided to pull ahead its plans and announced in September it would offer the Cummins ISB with SCR in its medium-duty trucks. Those trucks went into production and started shipping this month.

"Our order intake was 27%, our highest level of the year, so we're quite pleased with the direction so far," Allen said. "There's been a surge here of ISB orders as I indicated, over 6,000 of those," reflecting pent-up demand.

Looking ahead

"We enter 2014 with more work to do in areas of market share and warranty adjustment," Clarke said.

Navistar is forecasting a Class 8 industry of 220,000 to 230,000 retail sales in the U.S. and Canada for its fiscal year 2014.

In the fourth quarter, Navistar's Class 6-8 truck orders were up 12% over the third quarter and up 34% from the same quarter in 2012, Allen noted. "Meanwhile our backlog is up 26% year over year." Class 8 alone is up by a third compared to this time last year, he said, and Class 8 market share in Q4 was 16%, the highest this year.

Company officials expect the company will generate an additional $175 million in structural cost savings in fiscal year 2014, and projects its capital expenditures will be similar to 2013 spending. The company expects to end first quarter 2014 with manufacturing cash and marketable securities between $1 billion and $1.1 billion.

"Traditionally, our first quarter represents the low period of the year as volumes are lower due to the Thanksgiving and winter break downtimes, which is compounded this year by significantly lower military sales and the late-in-the-quarter ramp up of our Cummins ISB engine offering in our medium-duty trucks and buses," Clarke said.

"However, we anticipate stronger year-over-year performance starting in the second quarter, driven by higher volumes in truck, parts and our global operations and slightly improved pricing, coupled with ongoing structural and material cost improvements."

One thing you can expect is that Navistar will take steps to get rid of some of its excess engine manufacturing capacity. Officials say they aren't ready to make any announcements yet, because they are waiting to see how many of its own proprietary engines it sells vs. the Cummins engines.

"We will take steps this year to consolidate our manufacturing capacity," Allen said. "We have three plants for engines today. We don't need three."

New reporting segments

In connection with Navistar's renewed focus on its primary markets, the company has changed its reporting segments in the fourth quarter. In addition to the Financial Services segment, new segment reporting will now be as follows:

• North America Truck – primarily consists of core products of Class 4 through 8 trucks, buses and military vehicles along with engine production for the North America markets, including sales in the U.S., Canada and Mexico.
• North America Parts – primarily consists of proprietary products needed to support International brand commercial and military trucks, IC Bus brand buses and MaxxForce engine lines. North America Parts also provides other standard truck, trailer and engine aftermarket parts. The segment also includes operating results of Blue Diamond Parts.
• Global Operations – primarily consists of MWM engine and truck operations in Brazil and export truck and parts businesses outside of the core North America markets.

View the full earnings release on Navistar's website.