Atmus Filtration Technologies Inc. (ATMU) Earnings Call Transcript & Summary

It's a great point, and I wouldn't say that we have perfect clarity by any means. Largely speaking, it starts with end customer relationships as well as OE relationships. And so making sure that we're engaging with our customers, hearing what they have to say, asking the right questions. Obviously, we can track some of it in our order activity relative to what we see from the underlying market trends. And so you can kind of see when certain folks have worked through their inventory balances. And again, that was timed a bit differently last year. We don't have perfect system clarity. It's not as transparent as certainly we would like. But this is where engaging with our customers and ensuring that we maintain really open lines of communication is critically important.

Got you. So maybe talk about the medium term, the biggest revenue driver is winning first-fit platforms. In the first quarter, you had a competitor Fuel Filter win for a global OEM. So can you just talk about winning and how do you go and win these new platforms?

Absolutely. So from a -- from an emissions regulation standpoint that can tend to drive incremental opportunities to engage with customers to meet their first-fit needs. It's not necessarily driven by our filtration content as we think about compliance with those emissions regulations. We do have a little bit of that with our crankcase ventilation product but it's more driven by the fact that, first, the opportunities once secured, often aren't rebid out for obvious reasons, they don't want to change the certification. And so any time there's a new emissions regulation, there's a new first-fit, engine overhaul, for example, and that represents an opportunity for us to go to OEMs and pitch for new programs. So that's the catalyst, if you will. I would say the first at opportunities, maybe I split them across 3 categories. So the first is what we call winning with the winners. And so looking to engage with our current customers as they exploit opportunities to win share. A good example of this would certainly be with our largest customer, Cummins. On the back of the 2027 emissions regulations, they are winning new share given their ability to deploy R&D capital across a much larger volume level than others in the engine space. And this is a significant emissions regulation coming up, and so requires a significant amount of investment. And therefore, they've been able to announce some share gains that inherently pull through to our business. We've had a few others, in that example you mentioned the European OEM that we've highlighted. And so we continue to engage, particularly across some of our products that we tend to have a bit more technical differentiation also fuel programs as well as crankcase ventilation. The second bucket in the first-fit space would be now that we're fully separated from Cummins, going after some different OEM opportunities that weren't necessarily available to us under Cummins ownership. This is largely in the off-highway space as we think about OEMs who inherently compete with Cummins in the engine space. These are likely to be incremental opportunities. It's not like we're going to likely land a full suite of products of any of these OEMs but certainly represents an opportunity for us to engage with those customers where historically, we just had no point of connection. And then the third would be looking at some of the other opportunities in different pockets in the market. So maybe in the locomotive space, as an example, where we, again, historically just haven't focused, haven't deployed resources to engage with those customers historically driven by our strategic focus being in line with Cummins. And so excited about all of those different opportunities, it's a potential area for us to invest in to develop more relationships, certainly to develop programs for them. And what that will do is continue to pulse. We talk about a bit of a flywheel approach versus the aftermarket, where as you win new first-fit programs, you increase your installed base and then expose yourself to a longer aftermarket tail thereafter.

And Jack, maybe you can take us around the world and just highlight what are the emission regulations on the horizon by key regions that you think will matter for Atmus?

Yes, absolutely. So I would say the one that we've talked about is the 2027 emissions regulations coming up here in the U.S. The sourcing for those is occurring now, right, to enable start of production in that time frame. And so that's a big catalyst, I would say, at the moment, certainly expecting in Europe, Euro 7 to come on the heels of that. The timing of that has moved around a little bit. So I'm not quite sure where that will ultimately land. But sometime in the back part of this decade. We had relatively significant emissions regulations in a couple of other key markets, India and China, I guess, a couple of years ago now. And so we'd expect those to come on the heels of the European emissions regulation. And all of those regulations will help kind of dictate what type of technology is needed to meet those regulations, right? Is it the current internal combustion engine architecture? Is it an alternative fuel-powered internal combustion engine or something different?

So maybe we can talk about gross margins. You have an example of an automated plant in France. What kind of gross margin lift can automation bring to you?

Yes. So a key piece of our supply chain transformation, I would say, is the continued investment in our manufacturing capabilities. Historically, under Cummins, we were largely managed for cash, if you will. And so capital expenditures tended to hover in the 1.7% of sales range right at kind of that depreciation shield level. And so we've looked to increase that over the past couple of years and bring that more in line to a 2% to 3% capital expenditure range. Embedded in that, of course, is some maintenance CapEx, which tends to be a bit more in that 1.5% of sales range. And so above and beyond that, you've got growth capital, both in terms of increasing our capacity in things like media, which we did in 2023 and are concluding here in 2024. Investments in automation, like you highlighted, our green cartridge line in our facility in France and compare France. And then some smaller, I would say, targeted automation approaches, things like cobots, things like that, that can not only increase our efficiency in our plants but also increase our safety across many plants as we look to take things out. So I would say it's not -- it's a significant effort that we're undertaking that with time, we'll grow our efficiency levels in our plants. It's not a one big bang approach per se but excited about where that can take us.

But generally, how do you expand gross margins from here? What's the playbook?

Yes. So I think as we've looked at our gross margins, I would say it's a combination, right, of continued pricing to exploit market opportunities, particularly where we have strength, and we couple that with supply chain savings programs that certainly look to offset increasing costs, whether that be labor or whether that be material costs, et cetera. And obviously, we would hope to where available more than offset that. But the combination, I would say, of pricing and supply chain cost reductions to offset inflation is how we will look to continue to increase margins. We've had pretty significant margin expansion, as you can see in our results, over the course of 2023. And obviously, implying even with the modest top line growth, pretty strong incrementals inside of 2024.

And as you think about just automation as an opportunity, are you sort of thinking more about it given labor constraints because we've observed companies trying to sort of implement cobots? Or is it technology becoming more mature as I said, because I remember walking around like 10 years ago and everybody was going to buy cobots. And then they sort of didn't.

Yes.

So what has changed and what is driving that?

Yes. I would say, again, it's a continued deep dive into the efficiency across our manufacturing locations. Obviously, labor dynamics can vary depending on what region of the world you're in. And so there's a bit more opportunity perhaps in a place like France than some of our other locations. From a cobot perspective, I think it's...

But this technology, do, generally, you think the ecosystem is mature enough when you can start rolling it out?

Yes, I think it's developing, right? I think what we obviously are targeting is some of our lines that we feel are poised for growth, poised for high volume, low changeovers, those inherently lend themselves towards a more automated approach, if you will, versus some of our lower volume, high changeover lines where you need a bit more manual intervention. So on the cobot front, I think it's a combination of cost opportunities. I mentioned safety, certainly looking at areas within our manufacturing operations where you have some ergonomic constraints, those are going to lend yourself towards a cobot application.

Interesting. And just another question, I would be remiss not to ask it because I think it's such a hot topic, how are you thinking about sort of implementing AI for internal cost savings? And is it more -- how do you think -- you're the CFO, like when the C-suite gets together, what are the considerations for the use case?

Absolutely. It's a great question and one that we've been talking a lot about. I think you can look at a couple of different lenses, right? You can look at, first, I'd probably start with maybe the nearer-term opportunities across the functions and how can we automate and improve the use of AI. You look at the sales function, for example, can we increase our visibility with our customers? Can we look at pricing and whatnot through smarter technologies? I think there's a lot of potential there. From a finance perspective, using my own function, certainly looking at areas of automation. We've long been, I would say, a bit more manual than I would care for. Some of that's system dependent. But as you look at the power of AI, I think the opportunities are endless. I would say we're only scratching the surface in terms of the discussion standpoint. So...

So right now, it's more in the discussion phase?

Yes. And then looking for different areas that we can exploit as we identify the most value-add opportunities.

So let's talk about sort of on the cost structure. If you snap the line today at current commodity and freight costs, what would the year-over-year benefit be to gross margin '24?

Yes. So maybe I'll start with materials first. So I would say that largely, as we look at materials and where they're at right now, it would be flattish to 2023. Steel would be our biggest input cost. And so as we look at the index there, we did see a little bit of an increase in the first quarter. We tend to operate on about a 3-month flag. And so that will be a bit of a headwind as we move into the second quarter. We do expect that to moderate as we move into the third and fourth quarter. So all in, I wouldn't expect materials to be a significant mover year-over-year. Freight, I would say there's a bit of an anomaly in the first quarter. There was a rule change in Mexico. Mexico is one of our largest manufacturing location is, and so a bit of a rule change requiring an extra duty stamp. And so we incurred about $2 million of extra freight inside our first quarter that we expect to moderate as we move into the balance of the year. We were having to take our shipments for -- from Mexico all the way to the U.S. border and back just to accommodate this rule change. So we've navigated that now and are expecting that to freight, I would say, to be a tailwind as we move through the year.

And then just taking -- just zooming out maybe a little bit, you're in the thick of it, you are touching a lot of industries. What's your view on the inflation because we've heard a commentary -- and just maybe go into pricing as well, we've heard a commentary from a number of companies just inflation is at this permanently high plateau, and they're dialing in just more pricing into their business model going forward. How do you guys think about how sticky inflation is? And what does it mean? How do you offset it?

Absolutely.

Or not?

It's a great question. So we talk about our revenue algorithm over a long period of time for our business of 4% to 5%. And again, that's made up of 2% inherent market growth, 1% to 2% share gains and then 1% price. And so as you think about that 1% price, historically, it's not even really been at inflation levels. And so as we're operating in a higher inflationary period for longer, we're certainly looking at that and trying to identify what is the new normal, if you will, on pricing. It's not just a cost base. Obviously, working with our customers and what the market will bear and balancing share versus pricing opportunities. But I think as I think about the cost base, we do expect it to be continuing to increase year-over-year, and our intention is to preserve our margins through additional pricing actions.

Just to sort of think and then I'll shift to China M&A. But what's interesting is that as I observed some of your peers here in the inflationary period. Historically, our industry has lagged, right? Do you think, going forward, you guys collectively, the industry has gotten smarter about pricing sort of to be more proactive and keep up, right? Because it was a lot more reactive in the past, right? And do you think -- this last 4 years, do you think that has changed the algorithm for the industry and made the industry collectively just sort of rethink the go-to-market with the pricing mechanism?

I think absolutely, it's made everyone a bit smarter, if you will, on the pricing front. Look, I would love to be able to price ahead of cost increases. I'm not sure that dynamic will change. You're right, we have operated on a bit of a lag. We tend to price in the aftermarket, for example, at the beginning and the middle of the year. And so we tend to have that 6-month lag. Look, we're looking at it. I can't say that I don't think the fundamentals have necessarily changed. I do think that all the industry participants are a bit more cognizant of it and we'll look to react more quickly than...

No. It's just interesting. Collectively they have additional pricing and industrial has been fast than anything that people would do now versus 5 years ago, which was different. Maybe on China, do you see equity income from new China JV at full levels? It was up here already in the last 2 quarters, China always tough markets to have visibility? And what are you seeing in that market?

As you noted, it was up year-over-year in the last 2 quarters, although very slight. So I wouldn't read too much into that. Look, Steph, our CEO, who was just over in China a few weeks ago, and I wouldn't say solid, she didn't come back with many green shoots in terms of underlying market dynamics. So I think that will kind of continue to bump along is at the floor, perhaps, but I'm not sure that we see a lot of increases on the horizon in that market, certainly not within this year. I would say from a JV income perspective, I'd be remiss if I didn't highlight India. India is the larger piece of our JV income and we continue to see a lot of strength in that market and our expectations are for continued resilient growth.

And are you going to put more money into India?

It's a really key part of our operations. I would say from a region perspective, we see probably the highest growth across the world. We -- our joint venture there has a significant market share presence. And so we see it as a very key strategic region for us.

And just last on M&A. You highlight potential acquisition by year-end '24? Would you be disappointed if you did not announce something by year-end? And what's the average EBITDA size of prospects in the pipeline?

Yes. Look, I mean, with M&A, it's always hard to time as you can imagine. So it's a big piece of our strategy and one that we continue to have a lot of focus on looking to build that strategic pipeline. Again, we're kind of looking across the industrial air space, industrial water, industrial liquids, and looking to do that in a programmatic approach. So think in the revenue sizes of [ 50, ] [ 100, ] that kind of ranging. And so we continue to canvass the market and we'll update you all when we have more clarity.

Yes. That's terrific. We're right on time. Jack, it's been a pleasure. Thank you so much.

Thank you, Andrew. Thank you, everyone, for your interest.

Thank you. Yes.