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 Part II, Item 1A. "Risk Factors" and "Cautionary Note Regarding Forward-Looking Statements." 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 (the "Company," "our," "us," "we" or "Allison"), design and manufacture fully-automatic transmissions for medium- and heavy-duty commercial vehicles, medium- and heavy-tactical U.S. military vehicles and hybrid-propulsion systems for transit buses. We generate our net sales primarily from the sale of transmissions, transmission parts, support equipment, military kits, engineering services and extended transmission warranty coverage to a wide array of original equipment manufacturers ("OEMs"), distributors and the U.S. government. Although approximately 80% of our net sales were generated in North America in 2011, we have a global presence, serving customers in Europe, Asia, South America and Africa. We have approximately 2,800 employees and 12 different transmission product lines. We serve customers through an established network of approximately 1,500 authorized independent distributors and dealers worldwide. Since the introduction of our first fully-automatic transmission over 60 years ago, our products have gained acceptance in a wide variety of applications, including on-highway trucks (distribution, refuse, construction, fire and emergency), buses (primarily school, transit and hybrid-transit), motorhomes, off-highway vehicles and equipment (primarily energy, mining and construction) and military vehicles (wheeled and tracked).

Recent Developments

During the second quarter of 2012, we entered into co-development agreements with third parties to complement our portfolio of products and product initiatives. The agreements required us to invest $8.0 million in the form of a convertible loan and equity. Due to the current financial position of the third parties, we fully impaired the investments. While financially the investments have been fully impaired, we believe that the investments will provide us with advanced technology to complement our current transmission product offerings and product initiatives.

Trends Impacting Our Business

Our net sales are driven by commercial vehicle production, which tends to be highly correlated to macroeconomic conditions. The recent global economic downturn led to a significant decline in annual commercial vehicle production volumes. According to America's Commercial Transportation Research, commercial truck and bus production volumes in our North American on-highway markets are projected to continue to grow, but to remain below the 1998-2008 average production levels through 2014. However, we believe the anticipated increase in global commercial vehicle production, together with pent up demand in the North American market that resulted from the deferral of purchases during the economic downturn, will support our continued growth and result in increased net sales.

Second Quarter Net Sales by End Market (in millions):



                                                    Q2 2012            Q2 2011
End Market                                         Net  Sales         Net  Sales         % Variance
North America On-Highway                          $        217       $        189                 15 %

North America Hybrid-Propulsion Systems for
Transit Bus                                       $         18       $         40                (55 %)
North America Off-Highway                         $         44       $         70                (37 %)

Military                                          $         80       $         69                 16 %
Outside North America On-Highway                  $         78       $         77                  1 %
Outside North America Off-Highway                 $         30       $         21                 43 %
Service, Parts, Support Equipment & Other         $         92       $         90                  2 %

Total Net Sales                                   $        559       $        556                  1 %

North America On-Highway end market continued its recovery with net sales up 15 percent for the second quarter 2012 compared to the second quarter 2011. Rugged Duty Series and school bus models were the primary drivers of this performance followed by a smaller increase in motor home models. These increases were partially offset by reduced Highway Series models. We expect continued growth in this end market in the second half, though at an appreciably slower rate than what we have experienced year to date, given diminished commercial vehicle production forecasts.

North America Hybrid-Propulsion Systems for Transit Bus end market net sales were down 55 percent for the second quarter 2012 compared to the second quarter 2011 principally due to intra-year movements in the timing of orders. We believe second half net sales will be higher relative to the level experienced in second quarter of 2012.

North America Off-Highway end market net sales were down 37 percent for the second quarter 2012 compared to the second quarter of 2011. The year over year second quarter decrease was principally driven by decreased demand from hydraulic fracturing applications due to weakness in natural gas pricing. We believe second half year over year comparisons will continue to be challenging due to the strong demand we experienced last year and into the first quarter of 2012 and that second quarter net sales are more reflective of the demand level we can expect for the remainder of the year.

Military end market net sales were up 16 percent for the second quarter 2012 compared to the second quarter 2011. The year over year second quarter increase was principally driven by increased wheeled military products requirements. Due to anticipated reductions in U.S. defense spending we continue to expect a decline in net sales for the second half of 2012 compared to the prior year.

Outside North America On-Highway end market net sales were up 1 percent for the second quarter 2012 compared to the second quarter 2011, reflecting strength in China and Latin America being offset by a weaker environment in Europe. Despite challenging economic conditions, we continued to pursue our strategic priorities including regional marketing efforts to increase the penetration level of fully-automatic transmissions and attainment of additional vehicle releases in key emerging growth markets. We expect second half net sales in line with the prior year level due to increases in emerging markets offsetting continued weakness in European end markets.

Outside North America Off-Highway end market net sales were up 43 percent for the second quarter 2012 compared to the second quarter 2011. The increase was principally driven by continued strong demand from the mining and energy sectors. We expect continued double-digit year over year growth in second half net sales driven by the energy and mining sectors and our increased penetration in these end markets.

Service parts, support equipment & other end market net sales were up 2 percent for the second quarter 2012 compared to the second quarter 2011. The increase was principally driven by price increases on certain products, support equipment sales commensurate with increased transmission unit volume and increased global on-highway service part sales partially offset by decreased global off-highway service parts sales. We expect second half net sales to be in line with the prior year level.

Key Components of our Results of Operations

Net sales

We generate our net sales primarily from the sale of transmissions, transmission parts, support equipment, military kits, engineering services 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 most significant 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 six months ended June 30, 2012, direct material costs were approximately 71%, overhead costs were approximately 23%, and direct labor costs were approximately 6% 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 commodity swap contracts and, beginning in 2011, long-term supply agreements. See "-Quantitative and Qualitative Disclosures about Market Risk - Commodity Price Risk."

Selling, general and administrative expenses

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. In 2009, we were notified by the Department of Energy ("DOE") that we were selected to receive matching funds up to $62.8 million from a cost-share grant program funded by the American Recovery and Reinvestment Act for the development of hybrid-propulsion system manufacturing capacity in the U.S. (the "Grant Program"). Applicable costs associated with the Grant Program have been charged either to engineering - research and development or capital assets. The DOE's matching reimbursement is recorded to Other (expense) income, net in the Condensed Consolidated Statements of Comprehensive Income (Loss), or in the case of capital expenditure, as a reduction in the cost basis of the capital asset.

Non-GAAP Financial Measure

We use Adjusted net income to measure our overall profitability because it better reflects our cash flow generation by capturing the actual cash taxes paid rather than our tax expense as calculated under accounting principles generally accepted in the United States of America ("GAAP") and excludes the impact of the non-cash annual amortization of certain intangible assets that were created at the time of the acquisition and other certain non-recurring items. We use Adjusted EBITDA, Adjusted EBITDA margin and Adjusted free cash flow to evaluate and control our cash operating costs and to measure our operating profitability. We believe the presentation of Adjusted net income, Adjusted EBITDA, Adjusted EBITDA margin and Adjusted free cash flow enhances our investors' overall understanding of the financial performance and cash flow of our business.

You should not consider Adjusted net income, Adjusted EBITDA, and Adjusted EBITDA margin as an alternative to net income, determined in accordance with GAAP, as an indicator of operating performance. You should not consider Adjusted free cash flow as an alternative to net cash provided by operating activities, determined in accordance with GAAP, as an indicator of our cash flow.

A directly comparable GAAP measure to Adjusted net income and Adjusted EBITDA is Net income. A directly comparable GAAP measure to Adjusted free cash flow is Net cash provided by operating activities. The following is a reconciliation of Net income to Adjusted net income, Adjusted EBITDA and Adjusted EBITDA margin, and a reconciliation of Net cash provided by operating activities to Adjusted free cash flow:

                                                     For the three                   For the six
                                                     months  ended                  months  ended
                                                        June 30,                      June 30,
                                                      (unaudited)                    (unaudited)
(in millions)                                      2012          2011           2012            2011
Net income (loss)                                $  412.8       $ (17.2 )     $   470.8       $    19.7
plus:
Interest expense, net                                34.1          71.0            74.8           120.6
Cash interest                                       (52.7 )       (84.9 )         (88.8 )        (114.8 )
Income tax (benefit) expense                       (350.1 )         6.0          (324.9 )          24.0
Cash income taxes                                    (3.5 )        (2.1 )          (6.4 )          (3.7 )
Fee to terminate services agreement with
Sponsors (a)                                           -             -             16.0              -
Technology-related investments expense (b)            8.0            -              8.0              -
Initial public offering expenses (c)                  0.4            -              6.1              -
Amortization of intangible assets                    37.5          38.0            75.0            76.0

Adjusted net income                              $   86.5       $  10.8       $   230.6       $   121.8
Cash interest expense                                52.7          84.9            88.8           114.8
Cash income taxes                                     3.5           2.1             6.4             3.7
Depreciation of property, plant and equipment        25.3          25.8            49.9            51.5
Loss on repurchases of long-term debt (d)             7.6           8.3            21.1             8.3
Dual power inverter module extended coverage
(e)                                                   9.4            -              9.4              -
Benefit plan re-measurement (f)                       2.3            -              2.3              -
Unrealized loss on hedge contracts (g)                1.7           2.6             1.0             1.0
Premiums and expenses on tender offer for
long-term debt (h)                                     -           56.9              -             56.9
Benefit plan adjustment (i)                            -           (2.0 )            -             (2.0 )
Restructuring charges (j)                              -            0.6              -              0.6
Other (k)                                             1.7           3.0             4.2             5.7

Adjusted EBITDA                                  $  190.7       $ 193.0       $   413.7       $   362.3

Net sales                                        $  559.4       $ 555.7       $ 1,161.3       $ 1,072.7
Adjusted EBITDA margin                               34.1 %        34.7 %          35.6 %          33.8 %

Net cash provided by operating activities        $  106.9       $  83.8       $   246.5       $   193.7
(Deductions) or additions to reconcile to
Adjusted free cash flow:
Additions of long-lived assets                      (26.8 )       (16.0 )         (62.5 )         (27.6 )
Fee to terminate services agreement with
Sponsors (a)                                           -             -             16.0              -

Adjusted free cash flow                          $   80.1       $  67.8       $   200.0       $   166.1

(a) Represents a one-time payment (recorded in Other (expense) income, net) to terminate the services agreement with affiliates of the Carlyle Group and Onex Corporation ("Sponsors").

(b) Represents an $8.0 million impairment charge (recorded in Other (expense) income, net) on investments in co-development agreements with various companies to expand our position in transmission technologies.

(c) Represents $0.4 million and $6.1 million of fees and expenses (recorded in Other (expense) income, net) related to our initial public offering in March 2012 for the three and six months ended June 30, 2012, respectively.

(e) During the second quarter of 2012, we increased our liability related to the Dual Power Inverter Module ("DPIM") extended coverage program due to claims data and additional design issues identified during introduction of replacement units. The increase in liability resulted in a charge of approximately $9.4 million (recorded in Selling, general and administrative expenses) for the three and six months ended June 30, 2012.

(f) Represents a $2.3 million settlement charge (recorded in Other (expense), income, net) related to the transfer of pension obligations for certain qualified hourly employees from our hourly defined benefit pension plan to General Motors' pension plan as part of the Asset Purchase Agreement.

(g) Represents $1.7 million and $2.6 million of unrealized losses (recorded in Other (expense) income, net) on the mark-to-market of our foreign currency and commodities contracts for the three months ended June 30, 2012 and 2011, respectively. Represents $1.0 million and $1.0 million of unrealized losses (recorded in Other (expense) income, net) on the mark-to-market of our foreign currency and commodities contracts for the six months ended June 30, 2012 and 2011, respectively.

(h) Represents $56.9 million (recorded in Other (expense) income, net) of premiums and expenses related to the tender offer for ATI's 11.25% senior toggle notes due 2015 ("Senior Toggle 11.25% Notes") in the second quarter of 2011.

(i) Represents a ($2.0) million ($0.7 million recorded in Cost of sales, $0.7 million recorded in Selling, general and administrative expenses, and $0.6 million recorded in Engineering - research and development) favorable adjustment related to certain differences between benefits promised under a certain benefit plan and the administration of the plan.

(j) Represents $0.6 million ($0.1 million recorded as Cost of sales and $0.5 million recorded as Engineering - research and development) of restructuring expenses related to a second quarter 2011 salaried employee headcount reduction program.

(k) Represents employee stock compensation expense and service fees (recorded in Selling, general and administrative expenses) paid to the Sponsors.

Results of Operations

The following tables set forth certain financial information for the three and six months ended June 30, 2012 and 2011. The following tables and discussion should be read in conjunction with the information contained in our condensed consolidated financial statements and the notes thereto included in Item I of this Quarterly Report on Form 10-Q.

Comparison of three months ended June 30, 2012 and 2011

                                                             Three months ended June 30,
                                                               %                                    %
(unaudited, dollars in millions)           2012          of net sales           2011          of net sales
Net sales                                 $ 559.4                   -         $  555.7                   -
Gross profit                                251.9                 45.0 %         244.5                 44.0 %
Operating expenses:
Selling, general and administrative
expenses                                    109.1                 19.5            96.7                 17.4
Engineering - research and
development                                  23.2                  4.1            28.2                  5.1
Total operating expenses                    132.3                 23.6           124.9                 22.5

Operating income                            119.6                 21.4           119.6                 21.5
Other expense, net:
Interest expense, net                       (34.1 )               (6.1 )         (71.0 )              (12.8 )
Premiums and expenses on tender offer
for long-term debt                             -                    -            (56.9 )              (10.2 )
Other expense, net                          (22.8 )               (4.1 )          (2.9 )               (0.5 )

Total other expense, net                    (56.9 )              (10.2 )        (130.8 )              (23.5 )

Income (loss) before income taxes            62.7                 11.2           (11.2 )               (2.0 )
Income tax benefit (expense)                350.1                 62.6            (6.0 )               (1.1 )

Net income (loss)                         $ 412.8                 73.8 %      $  (17.2 )               (3.1 )%

Net sales.

Net sales for the quarter ended June 30, 2012 were $559.4 million compared to $555.7 million for the quarter ended June 30, 2011, an increase of 0.7%. The increase was principally driven by a $31.0 million, or 9.0%, increase in net sales of global on-highway commercial products, parts and other products and an increase in net sales of $11.0 million, or 16.0%, in military products primarily driven by wheeled product requirements, partially offset by a decrease in net sales of $22.0 million, or 55.0%, for hybrid-propulsion systems primarily driven by intra-year movements in the timing of orders and a decrease in net sales of $17.0 million, or 19.0%, of global off-highway products driven by lower demand from natural gas fracturing applications due to weakness in natural gas pricing.

Gross profit.

Gross profit for the quarter ended June 30, 2012 was $251.9 million compared to $244.5 million for the quarter ended June 30, 2011, an increase of 3.0%. The increase was principally driven by $7.0 million of price increases on certain products, $4.0 million attributable to improved manufacturing performance and $1.0 million of favorable material costs, partially offset by $4.0 million of unfavorable product mix and $1.0 million of unfavorable foreign exchange.

Selling, general and administrative expenses.

Selling, general and administrative expenses for the quarter ended June 30, 2012 were $109.1 million compared to $96.7 million for the quarter ended June 30, 2011, an increase of 12.8%. The increase was principally driven by $9.4 million related to the DPIM extended coverage program and $4.6 million of favorable product warranty expense adjustments in 2011, partially offset by lower global commercial spending activities.

Engineering - research and development.

Engineering - research and development expenses for the quarter ended June 30, 2012 were $23.2 million compared to $28.2 million for the quarter ended June 30, 2011, a decrease of 17.7%. The decrease was principally driven by $6.2 million of higher 2011 technology-related license expense, partially offset by higher product initiatives spending.

Interest expense, net.

Interest expense, net for the quarter ended June 30, 2012 was $34.1 million compared to $71.0 million for the quarter ended June 30, 2011, a decrease of 52.0%. The decrease was principally driven by $23.4 million decrease in mark-to-market expense for our interest rate derivatives, $15.3 million of lower interest expense as a result of debt repayments and purchases, and $3.4 million of lower amortization of deferred financing fees, partially offset by $4.7 million of higher interest expense primarily due to the effectiveness of $700.0 million of new interest rate swaps at higher interest rates.

Premiums and expenses on tender offer of long-term debt.

During the quarter ended June 30, 2011, we completed a cash tender offer to purchase any and all of our Senior Toggle 11.25% Notes. The tender offer resulted in us purchasing $468.1 million of $505.3 million of our outstanding Senior Toggle 11.25% Notes with premiums and expenses totaling $56.9 million.

Other expense, net.

Other (expense) income, net for the quarter ended June 30, 2012 was ($22.8) million compared to ($2.9) million for the quarter ended June 30, 2011. The increase in expense was principally driven by an $8.0 million impairment of technology-related investments, a $3.9 million favorable vendor settlement in 2011, $2.7 million of unfavorable foreign exchange, $2.3 million settlement charge related to the hourly defined benefit pension plan, $2.0 million of lower realized gains on derivative contracts, $1.8 million of decreased Grant Program income, $0.4 million of fees and expenses related to our initial public offering and $0.4 million of lower miscellaneous income, partially offset by $0.9 million of lower unrealized losses on derivative contracts and a $0.7 million decrease in premiums and expenses related to redemptions of long-term debt.

Income tax benefit (expense).

Income tax benefit for the second quarter of 2012 was $350.1 million resulting in an effective tax rate of 558% versus an effective tax rate of (54%) in the second quarter of 2011. The change in effective tax rate was principally driven by the release of our valuation allowance on our deferred tax assets resulting in an income tax benefit of $384.8 million. Management has determined, based on the evaluation of both objective and subjective evidence available, that a valuation allowance is no longer necessary and that it is more likely than not that the deferred tax assets are fully realizable.

Comparison of six months ended June 30, 2012 and 2011

                                                              Six months ended June 30,
                                                                %                                     %
(unaudited, dollars in millions)           2012           of net sales           2011           of net sales
Net sales                                $ 1,161.3                   -         $ 1,072.7                   -
Gross profit                                 535.7                 46.1 %          474.5                 44.2 %
. . .