Good morning. My name is Lisa, and I'll be your conference operator today. At this time, I would like to welcome everyone to the NFI Group Inc. Second Quarter Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pounds key. Thank you. Stephen King, you may begin your conference.
Thank you, Lisa. Good morning, everyone, and welcome to NFI Group's second quarter 2019 results conference call. This is Stephen King, NFI's Group Director of Corporate Development and Investor Relations speaking. Joining me today are Paul Soubry, President and Chief Executive Officer, and Glenn Asham, Executive Vice President and Chief Financial Officer. For your information, this call is being recorded, and a replay will be made available shortly after the call. Details on the replay can be found on our website. As a reminder to all participants and others regarding this call, certain information provided today is forward-looking and based on assumptions and anticipated results that are subject to uncertainties. Should any one or more of these uncertainties materialize or should the underlying prove incorrect, actual results may vary significantly from those expected.
You are advised to review the risk factors found in the company's press releases and other public filings on SEDAR for more details. In addition, we encourage all participants to review the Q2 2019 financial statements and the associated management discussion and analysis, MD&A, that are posted to our website and on SEDAR. To start today's call, I'll provide a few highlights of the quarter, Glenn will then speak to the financial results, and Paul will provide market insights and NFI's outlook. Following that, we'll open the call to analyst questions. The second quarter was a milestone for NFI as we successfully completed the acquisition of Alexander Dennis Limited or ADL, transforming NFI from a purely North American business to a leading independent global bus manufacturer. With the addition of ADL, NFI now has over 9,000 employees with an installed fleet of over 100,000 vehicles operating in 11 countries.
ADL solidifies NFI as the market leader in North America, plus brings market leadership in the U.K. and Hong Kong and provides a platform for future international growth. Since closing the acquisition, our accounting and finance teams have been busy converting ADL's results from a private company following UK GAAP to a public company following IFRS. A recognition of ADL's historic results, sorry, a reconciliation of ADL's historic results for fiscal 2018, Q1 2019, and Q2 2019 pre and post-acquisition are provided in the MD&A. Glenn will discuss the impact of ADL on NFI's overall financial results this morning. To provide a more comprehensive disclosure of financial performance, we've decided we will no longer issue a separate quarterly deliveries, orders, and backlog press release, and will now consolidate the deliveries, orders, and backlog information directly into our normal quarterly reporting within our MD&A.
As we have grown and diversified NFI, we found it limiting to only talk about part of our company's performance in our quarterly deliveries, orders, and backlog release, yet not provide the complete financial results. As such, we feel this change will benefit readers of our MD&A and financial statements to have the full picture at one time. This new reporting change will take effect starting with NFI's 2019 Q3 results. As for our legacy business, we continue to work our way through the learning curve of launching new vehicles in production at both New Flyer and MCI's facilities, supply chain challenges, the delayed start-up of our new parts fabrication facility, KMG, and ARBOC responding from the chassis supply disruption we experienced early in 2019. All of these factors have led to an increase in work in progress or WIP inventories, resulting in lower-than-planned deliveries so far in 2019.
We know the issues and are diligently working to recover. Paul will discuss this plan and other items when he comments on our outlook. While there were challenges, there were also numerous positives in the quarter, all of which will help NFI continue to defend our market leadership position and achieve our vision of enabling the future of mobility. A few highlights I'd like to specifically bring to your attention. In May, we announced that Kathy Winter, the Vice President and General Manager, Automated Driving Solutions Division of Intel Corporation, was elected as a director of NFI, bringing expertise and insights that can help us as we explore the world of autonomous vehicles.
NFI launched an autonomous bus program for advanced driver assistance systems and automated vehicles in partnership with Robotic Research, a U.S.-based innovative engineering and technology company that has provided autonomous solutions to commercial and government customers, including the U.S. Department of Defense. In addition, ADL already has an ADAS project underway in the U.K. New Flyer's infrastructure solutions team completed the installation of New York's first interoperable on-route charging solution. The Xcelsior CHARGE H2 fuel cell delivered 350 miles of zero-emission range in a California road test. MCI continued to deliver its new J35 coaches with very strong market response. Subsequent to quarter end, MCI received approval from New Jersey Transit for an additional 183 commuter coaches on its existing six-year contract.
ADL's new ultra-low emission Enviro400 City double-deck vehicles were put into service by First Glasgow as part of its premium Glasgow Airport Express service, ADL also secured a 50-vehicle order from Singapore's Land Transport Authority for double-deck buses featuring a new three-door, two-staircase layout. With that, Glenn will now take you through the second quarter 2019 financial highlights, and following that, Paul will provide some insights on our outlook.
Evening, and good morning, everyone. I will be highlighting certain second quarter 2019 results and provide comparisons to the same period in 2018. I direct you to NFI's second quarter 2019 financial statements and the MD&A of those financial statements, which are both available on SEDAR or NFI's website. I also want to remind you that our unaudited consolidated financial statements are presented in U.S. dollars, the company's functional currency, and all amounts referred to are as U.S. dollars, unless otherwise noted. As we previously announced, effective December 31, 2018, NFI adopted IFRS 16 for leases. This new standard provides a single lease accounting model, requiring lessees to recognize assets and liabilities for all major leases. We have elected to utilize the modified retrospective approach in adopting standard, and accordingly, comparative information for 2018 has not been restated.
Accordingly, all Q2 2019 numbers reflect the adoption of IFRS 16, while the comparative numbers have not been restated. Our MD&A clearly identifies the impact of the adoption of IFRS 16 on our financial results, and I recommend listeners review that information. We incorporated ADL's financial results into NFI from the acquisition date of May 28th, 2019, essentially one month in Q2 2019. The MD&A includes historic financial information, as well as the separate post-acquisition ADL results. With the addition of ADL, NFI now delivers an even broader range of vehicles, including single-deck, double-deck, and articulated transit buses, motor coaches and motor coach bodies, low floor cutaways, and medium duty shuttle buses across various geographic jurisdictions. With this broad portfolio, we believe that certain historic performance metrics, such as average selling price per EU and adjusted EBITDA per EU, may no longer be appropriate to measure the company's comparable performance.
As a result, we have revised the MD&A and added additional focus on gross margins, earnings before interest and taxes, and separated unallocated costs and corporate SG&A from the existing manufacturing and aftermarket reporting segments. We have also provided revenue segmentation by geographic region to now reflect the international reach of NFI. Note that vehicle revenue and gross margins can vary significantly from geographic region and by individual contract. This is especially true for ADL. In reviewing our materials, you'll note that ADL did not positively contribute to NFI's second quarter 2019 results, but results were within management expectations, reflecting adjustments required from the conversion to IFRS that impacted the revenue recognition. ADL's first half 2019 results were similar to the first half of 2018, with the first and second quarter results varying due to the timing and location of specific vehicle deliveries.
In addition, some ADL deliveries that would have been recognized in the second quarter under UK GAAP will now be recognized in the third quarter under IFRS as a result of change in revenue recognition policy. For NFI's consolidated second quarter 2019 results, NFI generated revenue of CAD 683 million, an increase of 1% compared to the second quarter of 2018. Revenue from manufacturing operations increased by 1.5%, primarily from the addition of ADL. The increase was offset by lower volumes in our legacy manufacturing businesses, driven by the production and delivery challenges Stephen discussed at the beginning of this call. Revenue from aftermarket operations decreased by 1.9%, primarily driven by the CAD 8.8 million addition of ADL's parts business, offset by a CAD 2 million impact from Daimler's termination of MCI's distribution rights agreement for Setra motor coach and parts sales in the U.S. and Canada, and fewer fleet renewal programs.
Total gross margins decreased 21%. Manufacturing gross margins decreased 27.7%, driven by the same production inefficiencies that impacted revenue, including the learning curve from new products and the start-up of KMG. ADL experienced a $9.7 million loss in gross margins, primarily driven by the unwind of the fair market value adjustments related to the valuation of acquired assets. Aftermarket gross margins increased by 5.8%, primarily due to favorable sales mix and the addition of ADL. Total adjusted EBITDA of $81.1 million for the quarter decreased by 11%, again, due to the previously mentioned production issues. Net earnings decreased by $41.2 million, and earnings per share was down by $0.67 per share. In addition to the items that impacted gross margins, net earnings were impacted by $13.3 million of one-time transaction costs related to the acquisition of ADL.
Interest expense was also higher, primarily driven by a CAD 12.6 million non-cash mark-to-market loss on the interest rate swap and higher credit draws related to the acquisition of ADL. The interest rate swap fixed NFI's interest rate that we pay on CAD 600 million of long-term debt at 2.27% plus an applicable margin. Interest rate fluctuations will cause mark-to-market gains or losses, but the fixed rate is in place until October 2023. Adjusted net earnings-CAD 25.8 million or CAD 0.42 per share, decreased by 50% compared to Q2 2018. This was driven by the same impacts on net earnings, but adjusted to remove the one-time costs associated with the acquisition of ADL. The mark-to-market impact of interest rate swap has not been adjusted, as adjustments are expected on a quarterly basis, and the amount of the adjustment is dependent on movement in market interest rates relative to the contracted rate of 2.27%.
Our liquidity position of CAD 202.2 million as of June 30th, 2019, decreased from CAD 301.5 million in March 31, 2019. The decrease in liquidity primarily relates to the acquisition of ADL, the amount of capital returned to shareholders through increased dividends, as well as changes in non-cash working capital, which are expected to be recovered as work-in-process is reduced to normal levels. The company generated free cash flow of CAD 41.4 million during the second quarter of 2019, a decrease of 13% compared to Q2 2018. The decrease was primarily driven by lower earnings from operations, partially offset by lower capital expenditures. The company declared dividends increased by 12.3% from the same period in 2018, and represents a payout ratio of 49% versus 38% from Q2 2018. In March, NFI increased its annual dividend rate by 13.3%, from CAD 1.50 to CAD 1.70 per share, that's Canadian, for dividends effective March 13th, 2019.
Property, plant, and equipment cash expenditures decreased by 45.2%, or CAD 8.5 million compared to the second quarter of 2018. Planned capital expenditures for 2019 are expected to be lower than 2018, as major projects are nearing completion. Return on invested capital, or ROIC, for the period ending June 30th, 2019, was 11.2%, as compared to 15.5% for the same period in 2018. A lower ROIC was primarily as a result of material investments made in KMG, which is now expected to generate benefits until late 2019, plus higher inventory and lower adjusted EBITDA. Now I'll turn it over to Paul to provide you with market insights and our outlook.
Thanks, Glenn. Good morning, ladies and gentlemen. You've heard from Stephen and from Glenn talk this morning about the production challenges we've experienced in the first half of 2019 that resulted in us having reduced deliveries in the first half. We make no excuses. We accept responsibility. We know the root cause, we know the path forward, and we're well into our recovery effort, which is focused on lowering our WIP and delivering the vehicles to our customers. The result is expected to have a pronounced impact on the fourth quarter of this year as we get caught up. We've been asked a number of times if our due diligence and our acquisition effort of ADL in the first half of this year took our focus away from the core business. This is categorically not the case.
The good news is we're now a more diverse business more than ever, with a material backlog, leading positions in multiple markets and geographic jurisdictions, solid free cash flow generation, the highest EBITDA margin amongst our peers, a proven zero-emission bus offering, and a focus on returning capital to our shareholders. Now looking at our markets, let me start with North American public transit. As we expected, our bid universe has been growing with the active bids up 22% from the first quarter of this year. This increase supports our view that the second half of 2019 will see increased award activity, and we've already experienced this with nearly 200 EUs awarded to NFI and announced just this past week.
We expect an increase in the number of vehicle awards in the second half, but also expect that individual awards may be smaller in firm quantities with fewer options or shorter contract terms. As we've discussed before, this is primarily driven by transit agencies continuing to reassess and redevelop their five-year fleet replacement plans and to consider how and when they will approach Zero-Emission Bus or ZEB programs. As they do make that transition to ZEBs, we believe NFI will be beneficiary of this change. In North America, NFI offers what we believe to be the market's strongest ZEB platform, with a variety of clean propulsion approaches, including battery electric 35 and 40-foot single deck, 60-foot articulated, and now with ADL, double-deck variants.
As anticipated, we've already seen an increase in number of ZEB bids in our universe, and it now makes up a total of 20% of that total bid universe. To complement our ZEB, we also introduced and launched earlier this year our infrastructure solution service to assist transit agencies in understanding the infrastructure requirements for zero-emission buses and to help project manage the installation of the associated charging infrastructure. This has gone extremely well. The demand for low-floor cutaway and low-floor medium-duty buses also continues to be encouraging. While ARBOC's chassis supply disruption for our low-floor cutaways impacted our ability to deliver those vehicles in the first half, the demand remains strong, especially for our medium-duty product, where we build our own chassis, that generates higher margins. In addition to just the general diesel bus, ARBOC recently launched its electrification program for the Equess model.
In the motorcoach segment, we expect the public market to remain stable. While private motorcoach demand has declined, as we've seen in previous years, the private motorcoach business continues to be heavily weighted to the fourth quarter. MCI is also deep and continues its development testing of its electric motorcoach. For ADL's markets, the U.K. market is expected to be flat for the rest of 2019 before growing in 2020 as the large commercial operators and smaller regional players increase orders after a number of years of low activity. We expect ADL will be the beneficiary of this increased demand. ADL has the leading market share in single and double-deck battery electric buses in the U.K. and is now selling their Zero-Emission Buses in New Zealand.
ADL also expects to maintain its leader position in the cyclical Hong Kong market while it is coming off peak demand of 2017 and 2018. It is moving to lower but more stable deliveries, and helping to offset that lower demand in Hong Kong is the important contract win that Stephen talked about in Singapore and further penetration by ADL in New Zealand. Now, ADL's Plaxton motor coach business, which in this case builds bodies predominantly on Volvo chassis, is primarily focused on the U.K. market, which is expected to experience modest growth in 2019 and again in 2020. Sales outside the U.K. have been relatively small for Plaxton. However, they continue to explore opportunities to grow deliveries from new export markets.
As you know, last month, we revised our 2019 total delivery guidance down by 3.4% to reflect, A, the impact of the low-floor cutaway sales, the lower sales, and B, to reflect a slowing demand in private motor coach sales in the first half of 2019. With the addition of ADL to NFI, we've now added 1,400 EUs to NFI's total annual delivery guidance for 2019, which now increases the total to 5,660 EUs. In the case of ADL, we will count both the single and double-deck models as one EU, given they only consume one production slot, as opposed to New Flyer's 60-foot articulated buses that consume two production slots. Note that the ADL delivery guidance we just gave you covers only the period from May 28th, 2019, the acquisition date, to December 29th, 2019.
As mentioned a few times in this call, ADL's unit revenue gross margins vary significantly by geographic region and by product type. We again recommend that listeners review the adjusted ADL historical fiscal 2018 and Q1 and Q2 financial information provided within the MD&A to get a better understanding of ADL's potential impact on NFI's 2019 results. With respect to NFI Parts, they continue to be focused on numerous initiatives to counter competitive intensity and deliver profitable growth. These initiatives include added focus on these vendor-managed inventory programs that we have won, an enhanced product offering, and capabilities on a previously implemented common IT platform across our aftermarket business. NFI Parts is now exploring the absorption of the management and distribution of ARBOC and Cutaway parts, which is expected to provide an additional revenue stream going forward to NFI Parts.
ADL's parts business continues to focus on enhancing its own online parts and service platform, which they branded AD24, which provides industry-leading aftermarket support today to U.K. customers. ADL parts business is expected to grow as its fleet expands internationally. Our business has changed over time with the acquisitions of MCI, ARBOC, and now ADL. With these changes, our revenue diversity has added seasonality to our results. We now expect the second half of each year to be busier periods than the previous comparable periods, especially in the fourth quarter. In addition to the seasonality impacts, we also expect to have the second half of this year to be busy as we recover from our challenges at New Flyer and MCI in the reduction of our WIP.
Our WIP reduction effort is, as I said, already underway and expected to have a pronounced impact on the fourth quarter of this year. With ADL being the market leader in the U.K., we're carefully following potential impacts from the U.K.'s potential withdrawal from the European Union, more commonly referred to as Brexit. ADL, in our mind, differs significantly from many other U.K. manufacturers, as it has fewer cross-border sales with EU member states and has significant local U.K. supply base. For the most part, U.K. customer buses are made in the U.K., buses for the Far East customers are made in region, and buses for North America are made in North America. While the outcome of Brexit remains unclear with numerous potential scenarios, management at ADL is taking steps to mitigate potential risks.
A few things they're working on is diversifying their supplier base further, leveraging global third-party manufacturing partners, identifying components that may be impacted by tariffs or delays of entry into the U.K., and building appropriate inventories as required. ADL has an active currency hedging strategy in place to attempt to manage currency risk exposure. ADL also has numerous exciting opportunities in Europe, Latin America, and the Asia Pacific region that will help drive top-line growth in the future. We're extremely well-positioned to capitalize on the ZEB evolution, and we're gaining share in the employee shuttle coach space and medium-duty shuttle spaces. NFI is a long-term business, and we think shareholders should take a long-term view, not a focus on any specific quarter. Throughout our history, we've made accretive acquisitions, and we've used our balance sheet wisely to diversify and grow.
The ADL transaction is no different. As we now focus on deleveraging over the next 18-24 months, we're also maintaining our leadership positions and realizing the benefit of the significant investments we've made in our operations and to provide steady dividends. Obviously, the impact we had in the first half of this year has caused some turbulence. We will get through that. With the half year complete, we're executing on our plan to lower CapEx expenditures. We're now expecting it to be in the range of about $45 million-$50 million for the legacy NFI business. With the addition of ADL, CapEx now total will be approximately $50 million-$55 million for 2019. Ladies and gentlemen, at NFI, we're proud of our history. Now with ADL, we're even more excited about our future.
With that, I'll turn it over to Lisa to answer any of your questions.
Thank you. At this time, I would like to remind everyone, in order to ask a question, press star, then the number 1 on your telephone keypad. We'll pause for just a moment to compile a Q&A roster. Our first question comes from the line of Chris Murray from AltaCorp Capital. Your line is open.
Thanks, folks. Good morning. Just maybe going back to the delivery guidance and thinking about some of the cadence here. I guess the concern that a number of us have is just how do you deal with the inventory glut? You're looking to be pushing out a fair number of pieces of equipment in the back half of the year. Can you just talk about some of the risks around that? I think the thing that maybe is more concerning is, thoughts around being able to hit the coach number, because that seems to be more subject to market conditions as opposed to being contracted backlog at this point.
It's a really good question. Thanks, Chris. Let's go through each of them. Start with ARBOC. We've reduced the guidance, as you know, primarily because in our production environment, without the chassis, we lost the production slots, and so we reduced that. Very comfortable with the Equus, the medium duties that we talked about, and so there we revised down. We're comfortable. On the New Flyer front, we built up our WIP, unfortunately, primarily as a result of the delayed implementation of KMG and the parts that it was building to go to the production lines, as well as some supply challenges we had with a few suppliers, and then ultimately ramping up volume at the same time as we implement electric buses inside the factories. The New Flyer story for the back half of the year is really about two things.
A, the buses that we line enter, getting them through, and B, catching up on the excess WIP that we've created. The MCI story, we've adjusted the private market down a little bit in our forecast for the full year. MCI, too, had some excess WIP that it needs to burn down. You're absolutely right. A good portion of the MCI's work is not contractual, it's transactional. As we look back for the last 10, 15, 20 years, the third and mostly the fourth quarter has significant deliveries, some of which are sold, and we're building a custom coach for an operator, and some of which we sell from a buildup of inventory, what we call fast track, selling a coach, if you will, off the shelf. Different than in the public world, we maintain our own kind of little bid universe, if you will.
We have a database, if you will, of every single operator we've talked to, what their forecast is currently, what they've bought in the past, what their fleet looks like, what we expect them to come out for bid or quote in the next couple of months, and our ability to deliver those buses. Some of those buses, as I said, are buses we still need to build. Some of them are buses or coaches that we actually have in inventory. We've effectively handicapped our historical batting average of selling rate. It's not like we're just using an average or a number. We're using individual customer by customers based on our selling forecast. Is there risk? Always there's risk of us not being able to sell or, A, sell and, B, deliver on time for the year in rev rec.
The numbers we've given you are based on the latest scrubbed forecast from Ian Smart and his team over at MCI about what we think we can deliver.
You've also got to remember that it's not all just private markets in the excess inventory. There's a good portion of it that's also public market sales related to the new product launch. The issues there, and I'm sure Paul will get into that next, the issues on that is no different than what we deal with in the New Flyer business.
Right. The final business is ADL, so we just added the total number of units. We've had some calls from some of the analysts and investors saying, "Hey, we read your materials. How can ADL lose money in the first month that you own it?" The reality of it is the conversion of the business from UK GAAP to IFRS fundamentally changes the revenue recognition, and so the number of units that were actually built and shipped but not yet accepted or received by the customer causes that revenue to move over into July. That didn't concern us. That was the way we had expected that work to go.
The number of units that Colin Robertson and his team have forecasted for the rest of the year are again largely sold or defined slots with some like the motor coach world where we actually have to secure a customer, sell a bus, and then build it and deliver it by the end of the year. The numbers we've given to the market are based on our absolutely best scrub and our best estimate of a ramp-up delivery primarily in the fourth quarter.
Okay. If I was to think about, and this is where we're trying to maybe even sequence, because there's a lot of moving parts on this one. If I think about deliveries Q3 versus Q4, historically, you've taken shutdowns in Q3, and even small shutdowns in Q4 in some of your operations. What you're telling me, though, is you're comfortable with the level of inspection, the level of quality control that you've got, that you should be able to move these buses out the door by year-end. Although, I'm going to guess there's got to be some period-to-period variation.
There always is that, Chris. That's the challenge. Again, because every bus is different or largely different, the degree of variation and customization, and as you said, the inspection dynamic causes always some scenarios where we can deliver right on time and some where we have a little bit of a delay. Keep in mind that, as we said, even with the shutdowns you described, in the motor coach world, we're selling buses that some are already made as opposed to having to make them and get them through the production process. The shutdown doesn't have the same impact on MCI as it does on, for example, New Flyer.
Okay, fair enough. Just going back, when you did the order and deliveries update, you'd mentioned that your WIP had built and from looking at it, you've got 700 and at the time, at least you said like ex ADL, you had close to 800 units in inventory. We saw the impact on working capital. I guess, first question on this one, ADL, what does that do to your inventory number? Maybe a better way to think about it is, what's the normalized number once we get past this kind of thing? Glenn, if you want to just chime in, what do you expect for working capital for the remainder of the year, and where do you think that that should take you in terms of overall leverage as you sort of flush a lot of this stuff?
Sure. We'll look more at dollars than for the actual units. If you look at it, the cash that has been consumed in working capital since the beginning of the year is over $100 million, right? That's ex the add of ADL. We think for sure getting our WIP back to that normal level, substantially all of that should get recovered. ADL obviously adds some inventory, and I guess the best place, and I don't have it in front of me right here, but the best place to look at would be to look at the opening balance sheet that we have currently presented for ADL in the MD&A. What I would do there is I would take out the fair market value bump out of that inventory because that's going to flush through the system and not get replaced.
Really, if you look at the opening balance sheet pre fair value adjustments, that's sort of the level of inventory we would be expecting from ADL.
Okay. To your point, fair to think that you'll flush the CAD 100 million through the back half of the year, is that the right way to think about it?
Yeah, I guess looking at it, as we said, primarily in the second quarter.
Fourth quarter.
Fourth quarter. If you look at what we have to do to achieve it, step number one is to get the production lines healthy again so that buses coming off the line are shipped. That obviously doesn't deal with the offline inventory. That offline inventory then, once we can stabilize the production lines, gets focused on, which is the reason most of the recovery happens in the fourth quarter.
Okay. Just my last question, just turning to the aftermarket business for a couple seconds. Percentage margins on an EBITDA basis were actually pretty positive, a little higher than they've been in a little while. I know over the last year or so, there's been a lot of discussion around IT harmonization, some facility reorganization. Is this like an odd number for the quarter or is this just kind of structurally some of the changes that we've been seeing over the last few years coming to fruition?
I think this is structurally some of the changes. We have definitely seen a reduction in the amount of operating costs for that operation as we put together the IT systems and harmonize the management groups into one group. From the cost basis, I would say that is reflective of the business post combination.
The other thing, Chris, that's not a P&L issue, but a balance sheet issue is we're now in a position with the harmonized IT systems and the one rationalized facility where there's an ability to reduce some of the working capital for the spare parts inventory on the shelf that's part of the back half of this year's plan. That's the added value of just that much better planning systems.
Okay. Thanks, guys. That is my questions for now.
Thank you, Chris.
Your next question comes from the line of Cameron Doerksen from National Bank. Your line is open.
Good morning. Thanks very much. Maybe just a couple of follow-up questions on the ADL disclosure. I'm just wondering if you're able to give us how many actual buses were delivered by ADL in Q2. I know it was only one month, but I'm just trying to, I guess, figure out what's remaining to be delivered at ADL based on your delivery guidance for them for the next two quarters.
Well, basically you take that, what number did we give you? 1,500 or whatever and just subtract the deliveries.
1,400. Yeah.
What is the deliveries in?
I think it was around 500 in Q2.
What about for the one month that you owned it?
I thought it was around 150-ish.
Yes. Sorry. That's correct.
Okay. About 150 deliveries in Q2 for the month that you owned it.
Yeah. Yeah.
Okay. Perfect. Can you just talk a little bit more about the seasonality here? I'm just sort of looking back at the pro forma numbers you provided and Q2 last year for ADL was big, maybe not as much this year. I'm just thinking to sort of describe what the typical seasonality is for ADL or is there a typical seasonality? I know it's more back half loaded, but just sort of by quarter.
Yeah. Really have to look at it almost market by market. For sure the U.K. market is much like what we would see in MCI. It varies sort of to Q3, Q4. Similarly, the Hong Kong market would also be back end loaded and I guess one of the issues there that you see from seasonality, obviously the Hong Kong business has been falling off since the beginning of 2019, so some of that seasonality will be reducing.
Not falling off, but the natural cyclicality of the business.
Obviously there's the North American business, which is going to behave.
There should be less seasonality there. That's much like what we see in the transit business.
Okay. Just on maybe the final one for me, just on ADL. I just wonder if you can talk about your confidence here in the U.K. market rebounding in 2020. You've kind of mentioned 2019 may be flattish, but you're expecting a rebound in 2020. What gives you that confidence?
As you and I've talked actually in the past about the market in the U.K., if you look on the internet and look for macro bus deliveries in the U.K., it looks like it's been dropping fairly materially. We argue and look at specifically that was largely related to kind of smaller micro or mini type buses, which ADL doesn't participate in. ADL's U.K. business is dominated by, I'm going to say, 10 operators. I may have that number a little bit wrong, 10 major operators and then a number of regional operators. Just like New Flyer, where we're not selling one bus at a time, they're contractually typed businesses.
We're customer by customer, year by year, month by month, quarter by quarter, analyzing, working when there are piece hit the street, working on our win rates historically, looking at our competitors' viability and competitiveness, and building up our forecast associated with that. The rest is largely sold out for ADL, and it's an execution play. 2020 is a win, build, and deliver play. The difference between ADL and New Flyer is when you start the year, a smaller portion of ADL will be actually sold by the time you start the year. It's far closer to an MCI type dynamic. Our confidence is due diligence we did as part of the acquisition, and then the subsequent review and assessment and work with Colin Robertson and his team to come up with that forecast for 2020. It's not a market size type conversation.
It's a customer buildup.
Okay. No, that's great. That's all for me. Thanks very much.
Thank you, Cameron.
Our next question comes from the line of Kevin Chiang from CIBC. Your line is open.
Hey, thanks for taking my questions here. Maybe just going back to some of the comments you made, Paul Soubry, around the steps you're taking to kind of deal with some of the execution issues you faced over the past year or so. Wondering, one, with the plan in place, are you starting to see some improvements already, or is that something that likely won't start materializing in the third quarter here when you look at kind of all the various initiatives you're pursuing? Secondly, when you start integrating ADL here, as you integrate ADL here, just maybe lessons learned in terms of what you've experienced over the past year, and would you approach the integration of ADL maybe differently than you might have otherwise, let's say, 12-18 months ago?
Okay, great question. The primary dynamic in New Flyer is we stood up a KMG, so a part fabrication business to do two things. One was to enhance our Buy America capability so that we would get credit for now the increased U.S. content rule. The second issue was a profitability opportunity, because as we resource stuff from Canada or internationally to the United States, we made a decision that we thought most of what could be built through KMG, we could do ourselves. That there was a profit opportunity. The reality is we underestimated and did a poor job of implementing or launching KMG.
The reason why that's so important is that as we slowed down the sourcing of material from other places and began relying on KMG, which didn't deliver, so guilty as charged, we now ended up with buses on production lines that didn't have the parts, because as you know, in our New Flyer environment, we don't carry buffer inventories. It's a just-in-time, point of use strategy of building parts. Largely did it to ourselves. No excuse other than we got to fix that going forward, and we're comfortable with that. The second issue is, while that was going on, we were adjusting volumes across our facilities and introducing electric buses into every one of our production lines. We added a whole bunch of complexity to that average person on the line building the buses.
We thought we did a good job of planning, executing, prioritizing, training, all those things. The combination of part shortages and a model mix caused us to basically, and pardon my expression, but get constipated with our ability to deliver the buses. The recovery plan is, A, fix KMG so that the parts get to the main production line, and the ones that we're building right now get out on time. B, because the buses have gone through the production line and they now need parts that weren't there, you've got all kinds of rectification work for that excess inventory that Glenn talked about. The fix is get that healthy, and there will be a little of an impact in Q3, but the most part of the excess WIP gets out in Q4.
From lessons learned, we're not going to take ADL parts into KMG and start building parts for them to try and grab a little profit until we're very comfortable now that KMG can actually stabilize and take on more work. The other thing is that so far, ADL's strategy on electric buses is different than New Flyer's. In New Flyer, we basically take the same chassis frame and shell, and we basically implement the electric system on the bus, the battery system, the motors and so forth. In ADL's case, their strategy in the U.K. is to team with somebody that provides the chassis. It has not had the same impact on ADL as they've moved and implemented the manufacturing delivery of electric buses.
There's lots of lessons learned that we can get from NFI Parts, from Motor Coach and NFI that we're going to use and work with Colin Robertson and his team as ADL comes on board. The biggest integration, quote unquote, opportunity for New Flyer and ADL is in North America, which is about 25% or 30% of their business or whatever the percentage is. That's where we can start to think about common supply chain, insourcing versus outsourcing, facility optimization over time, overhead optimization or rationalization and so forth. That's not, as we said, we didn't base our business case on ADL based on synergies. We based it based on being able to coordinate and grow the business. If we grab some synergies, that's a bonus or a benefit to profit.
That's super helpful. When you think of the timeline to all the stuff you just mentioned, especially on the KMG front, is the expectation still to be basically at some sort of normalized run rate in 2020? Or is there still a bit of a ramp-up as we look in the first half of 2020 to get profitability or the extra costs associated with the ramp-up fully out of the system?
The question we had earlier from Cameron and Chris on volumes and so forth, we have currently forecasted, planned, and are executing to get the vast majority of the excess WIP we've created out in the first quarter. Because it's variable based on supply chain and customer inspection and acceptance and so forth, could some of that bleed into 2020? Absolutely it could. The vast majority we expect to get out in the fourth quarter.
That's helpful. Maybe just last one from me. If you were to look at maybe the cost, I don't even know if this is the right way to think about it, but the cost or the margin impact from these issues, and to the extent it when you look onto 2020, a lot of this reverses, is there a dollar figure you would put on this? Like this would've been a X, what are we, $10 million of EBITDA hit in 2019 when it's all said and done? Is it tough to quantify because there's a bunch of moving pieces here?
It's fairly tough to quantify. You got to look at a lot of the rectification costs is just going to be labor costs, which when you look at the total cost of the bus, is relatively small, 7%, 8% of sales. Could that go up 10%, 15% on those offline buses for sure. Again, you're talking about a relatively low cost piece of the overall cost of the bus. No significant change in obviously the material costs. There could be a small impact on margins as we go through the Q4 reduction in work process, but we wouldn't think it is significant. For sure, there's far more variation quarter to quarter just by mix of contracts than you would see from any impact on the cleanup of the work process.
The biggest benefit, Kevin, is going to be the burn down of the excess WIP which generates the cash that is ballooning our balance sheet right now.
Okay. Maybe just a clarification question. I apologize if you mentioned this. It looks like based on your guidance, you're going to deliver roughly 3,400 buses through the back half of the year here, give or take. Did you mention what % of that would've been, say, contractual versus what % of that is transactional? What is it that you know for certain you can deliver based on a customer order and what % you have to find the buyer when you look at that 3,400?
We haven't provided specific percentages, let's just talk about them again. ARBOC's dynamic, and again, relatively small in the grand scheme of things, but a high percentage of that, greater than 50% or 70% or off the top of my head roughly, is we already have a contract we've got to build and deliver. New Flyer, essentially all of the slots we know whose bus it is. It's a contractual dynamic, there's the build and deliver the new stuff and the catch up and execute of the excess WIP. MCI, as we talked earlier, has a reasonable portion of contractual, most of it's government of our public type customers.
The private operators, there's a percentage of them where we actually know we were going to sell 10 or two buses to these guys, but there's a lot of it that is still got to win the deal, got to deliver the bus, which is why we have that combination of, again, fast tracks or pre-built buses, and some of it is we still got to build a bus for a unique customer. ADL is a lot closer to New Flyer where the vast majority of 2019 is not about finding a customer, it's about build and deliver a bus.
I think a good thing to look at there, Kevin, is the firm orders and backlog that we gave in July, in the orders release, obviously excluding ADL, but for the New Flyer, MCI, and the ARBOC business.
That's it for me. Thank you very much.
Thank you, Kevin.
Our next question comes from the line of Mark Nevel from Scotiabank. Your line is open.
Hey, good morning, guys.
Mark.
Maybe just a couple questions on ADL. I think when you bought the business, I think you said a 7.3 times multiple. I think that would suggest about $55 million of EBITDA. I'm looking through the MD&A, again, LTM and sort of last year, it looks closer to sort of $35, $36 million of EBITDA. I'm just really not sure sort of what the difference is or how to bridge that gap or maybe my numbers are a bit off.
We set multiple was really based off the U.K. GAAP number, because that's all we had at the time.
Okay.
When you look at what has changed between UK GAAP and IFRS, the biggest single change would have been the revenue recognition, and the other significant change would be the treatment of their new product development cost. I would say probably three-quarters of this difference is revenue recognition, and obviously that's just a timing issue. From our valuation standpoint, as the cash flow doesn't change, we were very clear on what the cash flow was for this business. While the revenue gets recognized at different points, the cash still comes in as planned. The other part, which we knew about during our diligence, but couldn't fully quantify because they capitalize all their new product development, some of that would be true tangible assets, some of that would be soft engineering costs, which obviously in our world we expense.
We knew the adjustments were coming, we just couldn't quantify them until we could get inside the business and start peeling back and looking at the numbers.
Okay.
I guess, again, from our standpoint, we valued the business, looked at it a number of different ways. Probably the most significant of which was based on the cash flow generation of the business, and obviously that has not changed as a result of changes in accounting policies.
Maybe I'm just not fully getting it, but just on the revenue recognition, I'm just curious why or how that would cause so much of a significant impact?
You've got to look at it, there's two major adjustments. You got to look at really their U.K. business and then their export business.
The U.K. business, they were basically recognizing revenue at the time of the bus being ready to ship from the factory. Under our policies, we recognize revenue once they arrive at the customer, and the customer takes control of the product.
Okay.
Maybe that shifts revenue one to two weeks, right?
Yeah.
Not a significant risk. The other piece was on their international work, and there they were recording revenue on a long-term contract basis. They basically were recording revenue at specific milestones. Those milestones being when they completed the chassis, when they finished building the bus body, and when they delivered the bus to the customer or had buses ready to ship. For sure, obviously now we're recording as the bus arrives at the customer, so there's a significant gap. It can be up to 6 weeks from the time they start a bus to the time they finish a bus. Say the chassis is done sort of halfway through that process, or so say there's up to 4 or 5 weeks of difference on some of the components of revenue recognition.
Hey, Mark, just some color. It's not material information, just context. When they closed off June under now our ownership, historically they would have had rev rec for about 60 units. There was, for example, seven in the U.K. that were on their way to a customer. There was 41 that were in shipment to the Asia Pacific. There was 12 that were being delivered in Europe, again, historically, they would have had rev rec. There was four in North America that were on a truck on the way to the customer. Those 60 units, they would have historically recognized in June, now go into July.
Over time, all that'll sort itself out, but it just so happens that from the date of purchase to the end of the quarter, we found them in that situation where it's a bunch of units that never actually got scored for or got credit for.
Okay. You did touch on this, but again, just sort of curious, the volatility in Q1, Q2 this year versus last year. Again, it sort of all ties in, I guess, into the revenue recognition. Is it typical or going forward, is it going to look like this in the first half or potentially where there's a lot of volatility from one quarter to the next?
On ADL specifically, Mark?
Yeah, exactly. Yeah, sorry.
Well, yeah, I think so. It's kind of, as I said before, it's halfway between Flyer and MCI. It's close to Flyer where they're mostly multi-unit contracts, but it's like MCI where it's not in the bag as the year starts. There's going to be variability in ADL quarter to quarter, and now even more based on this rev rec dynamic, or at least for a while you'll see it amplified to what we would have seen ADL in the past.
If you look at their revenue split, approximately half is the U.K. As we said earlier, that revenue is much like MCI, where it's strong in Q3, Q4. That's just the nature of that market.
Right. Okay, guys. Thanks. I'll get back in queue.
Thank you, Mark.
Our next question comes from the line of Stephen Harris from GMP Securities. Your line is open.
Good morning, gentlemen.
Hi, Steve.
I'm just wondering if we can dig in a little more into KMG, which seems to be at the root of a lot of these production issues and inventory issues. If you can maybe let us know, on your assessment right now, sort of more qualitatively than quantitatively, what exactly went wrong, where you are in fixing it, and maybe what you would do differently if you had to do it over again.
Sure. It's a multi-cell production facility, and our experience historically is adding part fabrication to our existing manufacturing plant. Cut and weld and paint a bracket and put it on the bus beside it. Our desire and our wisdom was the two things I said before. One is grab U.S. content, the second was grab some profitability based on repatriating ourself. In the most part, the capability or the technology at KMG is building stuff that we've done in our other plants. We took a facility, we set up these nine cells, we put a leadership team in place, we put an IT system in place, we train these people.
Most of the people in that area come from a warehousing type environment, we're training people to get from somebody that stocks a shelf to somebody that's now assembling a part or building a wiring harness and so forth. We got some support and assistance from the state of Kentucky and the local area and so forth. At the same time, we started to slow down the sourcing of material as we in-sourced it. We shut off vendor A, we started building it inside KMG, and there was a ramp-up period, and the first couple of months of ramp-up were fine, but they were very small volumes. As that volume started to ramp up, it became crystal clear that the leadership team wasn't probably the right ones. We made those changes.
The second issue is the training and deployment and execution of the IT systems, the planning systems, and so forth should've been done better. The third is the underestimation of the volatility of the workforce and where people in most of our plants, once they come, they stay, and in this case, you have people leaving for CAD 2 an hour or CAD 0.10 an hour, going down the street and so forth. All those things conspired to have us now, a product line in New Flyer, sitting there waiting for a part from KMG that didn't come. Of course, the turbulence associated with that. If I could do it over again, I thought we had a good project plan in place. It turns out we didn't. We thought we had the right leader in place. It turns out we didn't.
What we've decided to do is slow it back down to the core level of components. We've re-outsourced the key components that we've been holding up to product lines. We've changed the executive oversight inside New Flyer to be able to handle and manage this thing. We've redeployed numerous people to the site to basically go right back to ground zero in training of systems, using of equipment, and so forth. The team in place now has stabilized KMG, the parts past due or the hours overdue is down by a factor of 90% of what it was two months ago. We're pretty comfortable that the parts coming out and the parts we're buying elsewhere are going to allow the build lines to build their buses.
We will now slowly ramp KMG back up to get back onto the business case plan that we set up a year and a half ago. We're not going to jerk it up too fast, given the lessons learned from the last time, nor are we going to start to put MCI or ADL parts in there until we feel that it's healthy, which is probably a year from now. The focus is primarily now on New Flyer parts and ARBOC parts. Again, as I said in my remarks, mea culpa in terms of project management. We've been pretty successful at the vast majority of our project management over the last 10 years in the implementations. This one got away from us. We're on it. We're going to fix it.
Perfect. Okay. Rest of my questions are asked and answered. Thank you.
Thanks, Stephen.
Our next question comes from the line of Jonathan Lamers from BMO Capital Markets. Your line is open.
Good morning. Do you have the number of units that ADL delivered over the first five months of the year up to the acquisition date?
We haven't disclosed it, Jonathan, because we just did from the acquisition period onwards. Then we've provided, I guess, the quarterly revenue and adjusted EBITDA in the MD&A. We did provide in the acquisition announcement the annual deliveries for ADL. That was on a UK GAAP basis, so there is a little bit of difference between the 2,533 units on a UK GAAP basis versus the IFRS number. Hopefully, if you look at the seasonality and the annual deliveries, it can give you an idea of what 2018 looked like, therefore, what 2019 looked like. We haven't disclosed the deliveries for the previous period.
Okay, I'm just trying to gauge by how much ADL unit volumes are expected to be down for 2019 versus 2020. Sorry, 2019 versus 2018.
Yeah, I think if you look at overall unit volumes, we've given our guidance of 1,400. The challenge with ADL, I think the biggest issue is the mix. It has such a pronounced impact and the geographic region to where the vehicles are delivered. If they have vehicles in APAC versus U.K. versus North America, the revenue and margin per vehicle is quite different. Realize that's a challenge I know for you as you're doing your modeling. Maybe we can take it offline, we can go through it. I think looking at the 2018 data that we provided tries to give the seasonality mix and the average revenue per unit.
Again, I think, if you look at the 1,400 and then what we've talked about here, you look at how the first half of this year played versus the first half of last year, I'd use that as the starting point. Then I guess in the quarter and the month that we did own ADL, they delivered 129 transit buses and 17 motor coaches.
Okay, thanks. Paul, on the motor coach business, can you remind us when the new models were introduced?
Well, we do a new model year of the traditional J and D models in the fall of each year. The new models, the additional models of the J3500, we, I think, delivered our first J3500s in the first quarter, so that started to ramp up January, February. It is being built on the same line as the J4500, so while they're similar buses and look the same, they are different. One axle versus two axle, and tooling, and a whole bunch of other issues. The other new bus model that we introduced was what we call the D45 CRT LE, which is the vestibule coach, and it started hitting the production line in late first quarter and into the second quarter, and it is built on the J line as well.
Of all the extra production costs that you've incurred over the first half, are the costs for running two lines now significant, or is the larger bucket going to roll off as you work through all of these inefficiencies during the initial ramp?
The answer to both is yes. Remember that the D line is a completely separate line, and we will continue to run with duplicate overheads on the legacy D lines until it is 100% gone. You have different sourcing effort, you have different engineering efforts, you've got different manufacturing engineers on the shop floor, different leadership, and so forth. We won't be till, I think, 2021 or 2022 before you have completely harmonized lines. We will, until then, always have a higher overhead rate per average unit coming out of the facility. The challenges associated with, just like a New Flyer, the same technicians, the same leaders, the same supply people handling a new product on a common line or our common J line will burn those excess costs, and those things will largely be behind us at the end of 2019.
Okay, thanks. For the transit business, Paul, you mentioned that you continue to expect order sizes and attached options to be smaller than previous years. Can you tell if those are improving a bit in the second half, and can you update us on what you're hearing from the customers? Are they still continuing to focus on electrification?
Well, it's a good question, and it's obviously very topical. It's not a one quarter or a half a year or a one-year issue. I think last quarter, and even in some of the individual conversations, I give an example of the average transit agency that's got 200 or 300 buses that had diesels or natural gas. They've now been directed to find a way to plan for electric. The politicians in that area have said by 2030, 2040, whatever, we'll be all electric. Those transit agencies continue to be in a mad scramble to do two things. A, try and select somebody to have a couple of pilot buses, figure out the impact on their maintenance garages and technicians and all drivers and so forth.
B, come up with a multi-year replacement plan without real clarity of where the incremental funding for more expensive buses, A. And B, charging infrastructure is going to come from. When we started the year, I thought we were hopefully clear to our investors that you're going to start to see a slowdown in the total bid universe. In fact, not the total, but the active bid universe. The total of what people say they think they're going to buy in the next five years continues to be very healthy and near record levels. Their inability to put out big competitions, and have smaller orders of electric to try. For example, I can't remember the transit agency, but about a week ago, there was an RFP on the street for 100 diesel buses. We had worked on a proposal, as had our competitors.
I think we actually even submitted the proposal. The transit agency, with their local municipality, decided, "You know what? We're not going to proceed with that. We're going to reissue an RFP, and we're going to try five electric buses." That's the dynamic that's happening in many, many cases across the U.S. Are they talking about electric? I don't think there's a transit agency that we've talked to in the last year that is not talking about electric and trying to figure that out. What we did also expect is as people started to get their head around when and how electric might fit for them, we've seen it over the last quarter, and again, we saw it here in the data we just released. The number in the active bid universe is starting to creep back up, which is a very positive sign.
In our remarks, we just wanted to make sure people realize this isn't elastic. It's not going to go from 5,000 or 6,000 actives down to 2 and then back to 5,000 or 6,000 overnight. It's going to creep its way back. We're quite encouraged with the number of RFPs that have come out. We're encouraged with what people tell us they're going to put in for RFPs. We've started to see some of the bigger electric RFPs of 30, 40, 50 as opposed to 2, 3, and 4. All those things we think bode well. The unfortunate part of it is that a lot of that big backlog that we have is going to burn down, which is the good news. We have orders that we can actually work through that are conventional diesel or natural gas or hybrid.
Some operators are nervous and skittish about going to full all-electric, and we ultimately think hybrids will go away because an all-electric makes much more sense. In the interim, we're seeing a bit of resurgence on hybrids. That certain transit agencies that today have no electric experience can get their feet wet, can get their technicians up to speed and their drivers and so forth. Apologize for the long answer, Jonathan, but hopefully that gives you some color of what we're hearing. The other good side of that is that our buses in service, and notwithstanding some initial teething pains in deliveries and charging dynamics, our buses in service have performed to or better than our expectations.
Not to add too much, but Paul mentioned it. I wouldn't take fewer options on an order as a sign of decreasing demand. It's just transit agencies wanting to maintain that flexibility as they look at the ZEB transition and battery electric. While there's more firm and maybe fewer options, it's not a change in demand, it's just transit agencies wanting to have that option going forward if they decide to procure more ZEBs in the near term.
The other thing you don't see, and quite honestly, we don't see until it happens, Jonathan, is we have state contracts. Historically, it was a customer by customer, and then there was some agencies working together to put a collaborative bid out. What's happened again in the last couple of years, and we tried to point to in our MD&A, is this concept of state contracts, where there's a schedule that the state has put out that anybody in the state and some other named parties can actually buy off that schedule. The problem is there's no defined quantities. There's nothing in our backlog for those state schedules. The minute we get an opportunity, we'll bid on it. We, again, still don't put it in our backlog because we don't know whether it's funded or whether it's going to proceed.
The minute we get awarded, it goes immediately to firm, and you're going to see, and have seen, I'm sure, over the last little while, announcements of 20 buses here, 50 buses there, which are off of a state schedule. We've been very successful in California and in Washington and in Florida, getting on those state schedules, which is now a new or a different way to buy transit buses.
Okay, thanks. That's a good answer. Maybe just one follow-on on that. Are there any levers that you can pull to manage through this situation, whether on pricing and can you just talk about how you would manage through a scenario where the orders remain at a similar level to where they were at the first half?
Well, all the components, when we wake up on July 1st and we make our plan for the rest of the year, we know which ones are under contract, we know under the contract which ones are firm, we know which customers we think they're going to exercise their option so that we can build slots. We know other people that have said they're going to put out a fast track RFP that we think in the next number of months they're going to put it out, we think we can build in this year. The pricing is a slippery slope because as we move to electric buses, the last thing we want to do is drop price, set new market rates for something that's maybe not sustainable for the long term.
As I've said, I think a number of times, so far, knock on wood, we or any of our competitors have not been irresponsible, irrational on electric bus pricing. Part of that is there's not enough history to know what go forward pricing and margin and cost will look like. We sure don't want to be price leaders just to try and grab a short-term volume. The good news is we have backlog and we have state schedules that allow us to manage that, and I think as whoever's question before, maybe it was Chris' or somebody's, but in the New Flyer case, for the rest of this year, it's not like we got to fill slots. It's an execution story. We're now filling slots in Q1 and Q2 of next year, either from backlogs, new bids, or from state schedules.
Okay, thanks for your comments.
Thank you.
Our next question comes from the line of Daryl Young from TD Securities. Your line is open.
Morning, guys.
Hey, Daryl.
Just a couple of questions from me. In terms of leverage, the expectations to de-lever down to 2 to 2.5 times, looks like it's been pushed out just slightly to 18-24 months. Is that a reflection of the inventory ramp up or lower cash flow expectations?
I'm sorry?
Say that again, please, Daryl, just to be clear.
The decision to term out the de-leveraging to 18 to 24 months post-acquisition versus within 18 months previously, is that a reflection of the inventory ramp up or is there a lower expectation for margins going forward?
I would say a lot of it is around the inventory ramp up and obviously, hopefully, we're going to get that back this quarter. A little bit of hedging there. I guess the other piece is revenue recognition, but again, that does not quite impact the cash flow overly. We haven't really changed the business plan, so it's just related to the work in process.
I think really, Daryl, it's just a way of being clear that we've got some turbulence right now. It's not changing our vision, a desire to de-lever back down and just giving a little bit more comfort or clarity or headroom, if you will, on our ability to get there. We sure didn't want to set unrealistic expectations given the roadblocks we've seen recently. I'm not so sure I can say, or I definitely cannot say that it's our expectation of lower margins.
Yeah, exactly. I think it was primarily the reflection of the WIP reduction half two of 2019 would be the main change for that, the few extra months added.
Okay, great. In terms of ADL, the CapEx expectations are very low for 2019. Do you guys foresee a ramp up in CapEx come 2020 as you prepare for the new Berlin order?
First of all, it's a very different operating model than we have in New Flyer, right? In the Asia Pacific region, they're utilizing third-party contractors to do their build. Very CapEx-light for that part of the business. The Berlin contract, there's some work to be done there to see how we end up building that. It could be built in the Scotland operations, or we could look at other outsource providers.
The Berlin contract has kind of 3 stages to it. The first is the pilots and proof of concept in service. The second is the first initial order, which is like 60 or 70 units. Then there's options that go out a couple of years up to 400 something units. The first pilots are being built in the U.K. facilities. In fact, I think it's the Scotland facility. As we think about the first tranche, the ADL's been very smart about keeping their options open. One is a scenario of building them in the U.K., one's a scenario of building them with a partner in Europe or Eastern Europe, and a third might be a Chinese build and then importing them back into Germany. So the gang has not been definitive on the way they want to approach that.
That's one of the things that really attracted us to ADL, is this variable strategy, depending on the dynamics of the time. The other issue associated with that is Brexit, and making sure that we don't commit to something that has an impact on our business. We have time, though, before those initial deliveries beyond the pilots. It's probably a year and a bit away before they start to happen. We've already had a lot of preliminary conversations with Colin and his team about how they might address it, and they do have various scenarios they're working on.
I think, Daryl, just to add, if you look at their historic financial statements under UK GAAP, where they used to capitalize new product development, so CapEx will probably look higher on a UK GAAP basis versus IFRS. That's primarily all expense. Then the other thing in our guidance, I guess, for 2019, just to note that the kind of $5 million guidance range that we provided, that's just for the seven months from the acquisition date onwards. In 2020, obviously, we have a full year of ADL.
Okay, great. That's all the questions from me. Thanks, guys.
Thank you.
Again, if you'd like to ask a question, that's star one on your telephone keypad. Our next question comes from the line of Stephen Harris from GMP Securities. Your line is open.
Just one follow-up from me. One of the things you were encouraging us in your commentary was to change the way we look at the company and to move away from a sort of an EBITDA per EU model and focus on other metrics like gross margin. Is this really a function of the increased complexity of the business or the greater variability between contracts? Or is there something else you're seeing that leads you to think we should be focusing, looking at the company differently?
It is. It's a really good question, Stephen. We really worked hard on trying to explain what we were doing. Pardon a little bit of a rambling here, context. When it was just New Flyer, it was easy because it was a kind of a per unit slot. It was North America. The pricing and margins between Canada and the U.S. was kind of comparable and so forth. We added NAVI. Again, it was easy. It was a simple discussion. We got Motor Coach added to the thing, the margin profiles have been changing and moving between coach and transit, the blend worked out okay.
The minute ARBOC came in, the average EBITDA per unit for a cutaway, where we don't include the chassis, or a medium duty, which the quantum is half or two-thirds of the price of heavy duty, started to screw up the averages. We spent a disproportionate amount of time trying to explain to people it's not a drop in margins, it's a mix dynamic and so forth. Overlaid with that, you still always had this per EU dynamic associated with two production slots and an ADL. The minute we bring ADL into the story, you've got such a wide mix. You've got double-decks that are either conventional natural gas or diesel or a hybrid. You got double-decks where you have a chassis provided from somebody else on electric. Now the average selling price and the average margin is very different.
You have single decks in different regions that have very different pricing and margin profiles. When we started a calculated EBITDA per EU number, it was like, "Oh my God, this thing is so different," there's 10 different components that an average is now meaningless. Then we tried to figure out, could we provide the same fidelity of data that we do in the North American environment based in the global markets? It's very difficult. We were crystal clear trying not to tell anybody there's no hiding or no other driving factor other than the story to tell is very much different today than it was before those things. We went back and researched a whole bunch of other reporters to try and figure out what do they do with those blended margins and mixes.
We looked at the global guys like Volvo or Daimler. We looked at some of different heavy equipment manufacturers and just really felt the most natural thing now with both product but also geographic diversification is a margin perspective and an EBIT perspective to be able to help the investor have a good handle on the trajectory of our business over time. The most natural time to do that was post the ADL investment.
In addition, we've also provided some additional information that we haven't done in the past. We've done more to break down our cost of sales between what is the truly direct cost related to those sales versus the overhead. You can get a bit of a feel for what variable is versus fixed cost in the cost of sales number, which is something that previously was not provided.
Great. Thank you. Appreciate that.
Thanks for bringing that up, Stephen, because it's been an issue we wanted to make people understand. It's not to hide, it's to amplify and provide a full story. The other thing that you didn't ask about, but just a comment, providing a release 15 days after the quarter on units disconnected from the financial realities causes the investor, the analyst, and us, for that matter, to spend a disproportionate amount of time telling part of the story at part of the time. We just felt the best way to do that is to tell the whole story as a comprehensive package, which you'll now see starting next quarter.
Great. Thank you.
Thank you, Stephen.
We have no further questions in queue. I'll turn back to the presenters for closing remarks.
Okay. Thanks everyone for joining us and for your questions. If you have any follow-ups, please feel free to reach out anytime. My contact information is on the website and in the press releases, and we look forward to speaking with you all again soon. Have a great day.
This concludes today's conference call. You may now disconnect.