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

All right. We're going to keep the discussions going with Atmus Filtration and Steph Fischer, CEO. I'm Joe O'Dea. I lead the multi-industry team at Wells Fargo. Stephanie, thank you so much for being with us this afternoon. Really appreciate it.

Thanks, Joe. Great to be here.

So to kick things off, let's just do a little bit of background. So if you can just kind of overview of Atmus Filtration, give us a little bit of a 30,000-foot view, that would be helpful.

Fantastic. So for many Atmus Filtration technologies will be new. We're a global business. We actually came out of Cummins. We IPO-ed last year in May of 2023 and just managed the full share exchange where Cummins no longer holds an interest. So the kind of this weird combination of a 65-year-old company, that's brand new and just 1 year old. And we are a global provider of filtration solutions, leading positions in the U.S., leading positions in India and China, along with our joint venture partners and offer a full product portfolio of filtration products, including fuel filtration, crankcase ventilation and lube filtration. We are about -- we support commercial vehicle markets, so about 60% on-highway commercial vehicle markets and 40% off-highway.

Perfect. So IPO was just over a year ago now. Previously, part of Cummins. Just talk a little bit about that rationale for the IPO and the timing of when that happened.

Yes. So really, the strategic rationale, and if I just put the hat of Atmus on for a moment, was really to unlock growth potential of Atmus as an independent company that we were not going to be able to realize our full potential whilst inside the ownership of Cummins. Certainly, we had constrained investment and capital whilst inside the ownership of Cummins. Our primary focus actually was servicing and supporting the broader Cummins business and not really seeking to realize our full potential by growth opportunities across our existing core markets, but also growth opportunity in other horizontal filtration opportunities across industrial filtration markets. So from our perspective, this has created an opportunity to realize our growth potential. We have a very clear growth strategy, 4 key pillars of our growth strategy are focused on growing in first-fit, growing profitable aftermarket, transforming our supply chain and then expanding into industrial filtration markets. From a Cummins perspective, this was really about allowing them to focus and recognizing that they were no longer the best owner for the continued growth of Atmus Filtration.

And then when you think about what you've had to accomplish over the past year and sort of standing up the business separate from Cummins, just talk about some of the key achievements there and then what the key focus is on things that still need to be done.

It's a big undertaking to disentangle a $1.6 billion global business from a large company like Cummins. We had a number of our business elements. We're operating as standalone. So if you think about our manufacturing facilities, our sales and marketing, they were operating very much stand-alone. But many of our functions that we needed to stand up as an independent company such as finance, HR, IT and our distribution centers, in particular, were centralized within the core Cummins functions. And so we've been undergoing a process to separate all of that, stand up a new company. We've got a fully independent Board of Directors now. And we are about 60% of the way through the separation activity at the end of quarter 1 of 2024 and expect to be fully concluded on that separation activity by the end of 2024. The things still to be done, I would say, is a lot around systems and IT transitions, our finance systems, for example, and then the remaining transition of our distribution centers. The majority of those are done, but we have Europe and South Africa still to transition, which will happen largely in the back end of 2024.

And one of the distinguishing factors for the company is the mix where it's roughly 80% aftermarket, 20% first-fit. Just talk about kind of why that is the case and that you have such a high mix toward the aftermarket piece?

Yes. So we have a very large installed base across our network that's been growing over many years. If you think about the split of our business, so we have 60% support of on-highway business, 40% off-highway and very heavily skewed to high-duty cycle equipment. And so has a large usage profile associated with aftermarket content that really drives a very large 80% share of our revenue in aftermarket and 20% in first-fit. That winning in the first-fit business through our technology advantage and through a well-known Fleetguard brand is critical to fuel the ongoing aftermarket.

And can you just talk about that a little bit more in terms of the life of the vehicle? And kind of what you think about you're selling into some of these larger vehicle architectures are going to be high-cost vehicles in terms of what your dollar content is relative to that price? And then what that consumption is over the course of a vehicle life?

Yes. So firstly, we think about filtration very much as a low-cost insurance policy, if you like, the cost of a filtration content on a Kenworth Truck, for example, would be, say, $300 on $150,000, $200,000 truck, right? So our customers really want to make sure that they invest in high-quality filtration capability. Then I would say there's a multiple of these are long-life trucks. So many of our vehicles running 10 to 15 years over the life cycle, and that drives with varying applications across the different applications we support. Obviously, the duty cycle drives differences in that, but a very high aftermarket multiple.

And then if we can pivot into the competitive landscape and just talk about what the competitive dynamics are out there, how competitive the environment is? And then what differentiates Atmus within that?

So broadly speaking, there are about 5 key players across the globe in the, what I would call, I guess, the commercial vehicle filtration market where we play today. There are those that are predominantly U.S.-based, like ourselves and have a very strong position in the U.S. And there are -- as that has a stronger position in Europe where we have a less strong position. So our strength at Atmus is really very much in leading position in the U.S. I talked about a leading position in India and China alongside our joint venture partners. And that strength is built in a number of key -- core capabilities. The first, I would say, is our technology advantage. We are a leader in fuel and crankcase ventilation globally. We have a leadership advantage in our separation capability. Core to that is our media technology, which the majority of that we do in-house and manufacture ourselves. This proprietary technology that we believe is distinctive and advantageous in protecting our customers' equipment. So technology advantage, our global brand of Fleetguard is recognized the world over and recognized as renowned for premium, high-quality product. Thirdly, I would say one of our core capabilities is a very extensive distribution network that we have. We have a multichannel pathway to market, which means that our product is available where and when our customer needs it. And finally, I would just talk about our long-lasting partnerships with OEM partners built over decades and decades. Cummins is a great example of that, but we have partnerships with many of the largest OEs in the world, and that has been built over decades and not easily replicable.

And if we think about that and maybe some concentration around Cummins and think about sort of really serving Cummins from within Cummins now serving comes from outside of Cummins. What percentage of your revenue comes from them? And how do you think about the risks associated with that or maybe there are opportunities. I'm not sure.

Yes. So the first thing is, it's been an interesting journey as we've separated from our previous parent Cummins and they are also our major customer. So we needed to make sure we stayed friends through the separation, as I describe it. But I would just say that Cummins is a critically important customer to us. They represented 17% of our revenues in 2023. And we believe we're well placed to continue to support Cummins in an extensive way into the future. Contractually, we have agreed to a long-term contract with Cummins that secures that business into the foreseeable future. And I feel really confident actually around our continued ability, particularly given our outstanding leadership position in the products that Cummins needs, to continue to support them into the future. What is nice about the separation for us is that it unlocks the opportunity to also focus on other customers, other customers that will potentially off limits to us previously under the ownership of Cummins that now want to discuss and have conversations with us about how we can bring advantage to support them into the future. We also have the opportunity now to allocate capital aligned with our growth strategy, so that we're not constraining our team in terms of going after those opportunities. And so that's how I see both -- I guess, the risks and the size of the Cummins business important for us and also the opportunity for us as we step out.

And what's it been like sort of post-separation bidding on work for Cummins as you've gone through that process, any sort of learning experiences or observations and how you bid for it and what your win rates are like?

Yes. So we've continued to win 100% of Cummins business. Full separation, I guess, really only happened just a quarter ago. So not a lot of lived experience of this just yet. Certainly, as we head into a critical change period, the 2027 emission cycle in the U.S., there's a large amount of business there, which we've already contracted and won with Cummins. So that is already secured as future business with them. So that's been our recent experience.

What does the time line look like when you get an emissions change like that. And so 2027 as a cutoff, but in terms of the discussions that you're having and by what point in time do you think that you're largely going to be engineered into solutions. So it's not like it's a 2027 cutoff for you necessarily?

Yes. No. It varies. It varies by customer. It varies by complexity of the solution that you're talking about. Certainly, I would expect most of those 2027 decisions have already been made now, and we're working on the development of those platforms and investing in them already.

And then I wanted to discuss filtration media a little bit and sort of the expertise that you have and how you differentiate that way. And so you did touch on how you make a lot of your own, but maybe just give us some context on what percentage you're making, what percentage you're sourcing and how you make those decisions to do one or the other?

Yes. So we make the decision to invest in our own media development really based on who can bring the most value. So we -- if you sort of look at where we're producing media today internally, it's where we have a proprietary technology advantage. That number one, we want to protect that having it in-house allows us to develop solutions for our customers that are unique that others can't replicate. So that's really where we look to maintain our media production in-house. Where media product -- certain media is more commoditized, it's not a clear differentiated advantage. Where scale is a significant part of the solution of value there. We do source that externally, where others can generate larger scale by servicing multiple parties, but the vast majority of our media production is in-house.

And maybe just a little bit of perspective on that in terms of when you're doing it in-house and talk about an example of an engineered solution and what it is about your -- what you're able to do versus it just want to be available sourcing it from outside?

Yes. So it's really about, I guess, the layering, the way that we use the media, the trialing of different solutions to separate liquids. If you think about biofuels and stepping into biofuels and separating water from biofuels and how you might do that more effectively, we would be able to do that seamlessly through our own ownership, right? And so that would be an example.

And then wanted to move to just the current environment. And I think coming out of the first quarter, the aftermarket actually trended better than expected. I think the first-fit maybe came in a little bit later than expected. The way the full year was updated, it was actually opposite. And so just sort of explain this a little bit more in terms of what you saw during the quarter and what that meant for the rest of the year?

Yes. So I think the quarter outcomes were not -- the favorable quarter outcomes in the first quarter were not significant enough for us to revise full year guidance. So we left guidance flat overall from a full year perspective. As we look at the outlook for the remainder of the year, our blended rate of market conditions, if you like, is made up of sort of 20% first-fit, 80% aftermarket with a heavy U.S. skew. And we are already seeing now the downturn in the first-fit market, so heavy-duty, medium-duty truck markets already in the forward orders now, we're starting to see that come down. And certainly, that's how we've projected it through the second half of the year. On the aftermarket side, we certainly expect freight activity to uptick in the second half. Now we haven't seen that turn yet. So a major indicator that I referred to on our earnings call that we use is the Cass Freight Index is an external indicator of freight activity in the U.S. That was certainly still trending negative year-on-year through April. And so we'll continue to watch that. We're continuing to wait to see the uptick in freight activity. And the Cass Freight outlook for the full year revised freight activity slightly down as well. So it's just more of a timing thing of when we see that turn in freight activity impacting our aftermarket business.

And you did gain some share in aftermarket in the quarter. Can you just explain sort of some of the drivers behind that, your expectations for the repeatability of that?

Yes. One of the primary drivers of share gain for us in the aftermarket, and it was predominantly in the U.S., is really around our distribution approach, building our distribution centers and focusing relentlessly throughout our business on availability. Availability is king through the aftermarket as we've been under the ownership of Cummins. Certainly, our distribution centers and largely inventory management, the distribution was through a centralized supply chain that also managed the broader first-fit requirements of Cummins. And you can imagine it's only 5% of the business, we were a small part of the focus of how things would be derived -- driven. Now we're very much driving our own distribution strategy, very focused on availability in the aftermarket, and that is translating into share gains in the aftermarket. The challenge that we had to solve was not really people wanted our product, and it was just that we weren't putting it in the hands everywhere that we needed to. And so we've seen some significant share gains there. And then the other part of the share gains I would talk about -- we talk about is quite often now about being partnered with the winners. We're pretty lucky in terms of the partnerships that we have. That they've been built over many, many decades, and our partnerships with the channel partners, they are winning. And we are winning along with them as they grow. And so they would be the 2 major elements of this share gain.

And then if we focus on the first-fit market, you talked about the mix of the on-highway and the off-highway piece of that. But if you think about -- if you dig into that a little bit more and think about the key verticals within the on-highway piece and the off-highway piece, just any color on the trends you're seeing, your expectations for how that moves, whether it's [ Cass Freight ] that's sort of the biggest headwind you'll see this year, how you're thinking about the off-highway piece as well.

Yes. Yes. So certainly, I think heavy duty is where we see the biggest headwinds in the on-highway space. As I said, Europe is significantly down. We are less exposed in Europe. So it's not a major driver for our business. But if we just talk about the market trends that already sort of started. Many customers talking about 18% down year-over-year in Europe, 7% to 10% in heavy duty in the U.S. market, and we're starting to see that come into play now. Medium duty is more flat. It's down -- flat to down 5%. So -- and that's about how we're seeing it play out. China remains really quite flat. I would say we're not seeing our shoots of growth come back there, and we continue to monitor that closely. And then finally, whilst you don't see that in our top line consolidated revenue results, we're optimistic about India and the continued positive trends in India in 5% of the growth rate there.

And what are you watching most closely to see that this year goes sort of according to expectations. And from a timing perspective, where in the year, is it most important to see that things start to kind of bottom out on the order trend side?

Well, so I think -- I'm just thinking about your last question, I didn't touch on the off-highway piece. So let me just come back to that. If you think about off-highway for us, it's roughly split between construction, mining and agriculture. And I'd say there are a some optimism in construction, but relatively flat across the others, more broadly speaking. So no major drivers there. I think the biggest thing we're watching for is just freight -- general economic activity and freight activity driving the aftermarket. That's the biggest thing we're watching. We do expect to have a more favorable climate in the second half. We saw destocking in the back part of 2023. And so we certainly, as we look to the second half here, we've got that tailwind as well.

And just talk about the flexibility required in the production side for first-fit in terms of how much visibility are your customers giving you? I imagine you're going to get some visibility on what the production schedules are, but maybe that's as small as 2 weeks or 10 days or whatever it is. And so how flexible do you need to be with respect to that?

On the first-fit side, it's a very sort of well-developed, mature process, I would say, and we've been in this business for a long time. We've already got a good line of sight to sort of the next 12 weeks of cycle. And so we blend that into our production schedules and are well planned for it. So it's a pretty well-oiled machine.

Okay. And then if we move to aftermarket and you touched on destock, but just give us a little bit of background on when you started to see that, how far through it you think you are?

Yes. So we think, by and large, destocking general industry is done and sort of was largely done through the end of 2023 for us, fourth quarter of 2023. Now we're just seeing sporadic, sort of, onetime customer impacts. So when did it take place as a comparative for 2023. I think that varies quite a bit in a varied customers for us. It sort of started in Q2. And then we had some customers still sort of destocking in Q4 of 2023. So you saw that impact across our business throughout 2023. And now I think we're largely through it.

And how about your visibility into channel inventory when we think about, I guess, your own distribution and then OEM distribution, how good is that visibility and your ability to track it?

I wouldn't say there's a systematic way of tracking it, but we've got good intel for our customers of where that's tracking And we, obviously, discussed with our customers where those inventory levels are pre supply chain -- supply crisis and so forth. And basically, I'd say most of that channel has moderated back. The one sort of exception I would call out is in China. And, certainly, I visit there just a couple of months ago. And I would say there's still stock levels through the dealer chain there that haven't worked all their way through.

And then in terms of the freight activity and how you're thinking about that and what's embedded within your expectations, can you just talk about what that recovery curve looks like, how -- the timing of when it gets better, how much better it gets?

Yes. So I think full year, we're looking at an aftermarket of. Flat to up 2%, I think, is the way we described it. And we see it progressively improving through third quarter and fourth quarter. It describes the evolution for the year.

Okay. Let's pivot now to the industrial markets. You talked about the strategic pillars, growth in industrial being one of them. Just explain that a little bit in terms of what you're thinking about for growth in industrial markets and the markets that are important to you?

Yes. So our growth in our core business is pretty easy to understand and get your head around and actually reasonably easy for us to get on with and execute. I think -- as I think about industrial filtration markets, there's a real opportunity for us to expand horizontally across filtration technologies. The industrial filtration markets in total, we estimate at 3x the size of the current core markets in which we operate and growing at twice the rate. Now that's a big bundle of industrial filtration and there's a lot within that. And so we've done a lot of work strategically on segmenting what markets, what applications, what parts of that industrial filtration market would we want to participate in? And more importantly, where do we have a right to win and how could we create value in doing so? And so we've been working on that strategy for some time. We've developed -- we do see this as being entering into this inorganically through M&A largely because we don't operate in these channels today, the customers are different. We do think there's certainly synergy across from our technology and our manufacturing capability and our global scale that we can leverage. So we're in the process of that. We're building a pipeline of targets. We're reviewing targets. We've reviewed several targets through due diligence and have decided not to proceed. So we're taking a very disciplined approach to this. We do believe this creates an opportunity for value upside. But obviously, want to balance the growth possibility here with strong returns and building a scalable platform for the future.

Is there a common denominator behind when you choose not to proceed with an opportunity and whether that's more valuation related or whether it's more sort of capability. And as you learn the business more, it's just not what you want to have?

Yes, it hasn't been valuation related. It has been largely around -- we don't want to just invest in something that will be able to deliver financial growth and returns, right? We're really looking to something that can be scalable into the future. And so that's been largely the limitation we've seen so far in some of the small assets we've looked at is lifting that to the -- being able to grow that to the scale that we would want to for an enhanced industrial filtration business.

And it's 3x kind of the markets that you're in right now. Explain a little bit the history of why it was never pursued previously as it could have been a growth opportunity.

Yes. It's pretty simple, really. Cummins was following its own strategy. And if you think about the filtration division within Cummins, our revenues were 5% of Cummins' overall revenues. It didn't -- industrial filtration markets did not align with the future strategy of Cummins. And so we just didn't get priority. I know myself, I lobbied for a particular investment in the time that I was in the leading the role in the filtration division. And just relative to other investment choices that Cummins needs to make, along with its strategy, it wasn't the priority.

And then you have organic and inorganic paths to sort of build out the industrial filtration side of things. But are there particular verticals where you're focused on organic as the priority and other verticals where you're focused on inorganic?

It is largely an inorganic play into industrial filtration. We are certainly looking at opportunities where we could take and invest in product development to expand. But I'd say predominantly what we see it as an inorganic play.

And what is it about the technology that's different from what you have now where it's hard to do this with an internal investment in R&D and it needs to be something that's acquired? And maybe just an example of a filtration process that's out there like they just don't line up closely enough.

And it's not even so much the technology that is the challenge for us. It's really acquiring the past to market in the channel and the customer base. And sure, we should -- we could grow that from a [ seeds ] up basis. It would just take a very, very long time. And so it's -- we do think there is opportunity to leverage across in technology. There's not a lot of overlap on the channel side for us.

Are there particular verticals that you're most focused on just because when you think about that 3x opportunity, they're going to be a bigger piece of it overall? Or do you think the growth profile is that much more attractive?

There are. I don't think we're ready yet to be able to share specifics of that. But as we refine our strategy, we're getting clearer and clearer on what those verticals are.

And then just regionally, then the opportunity set where your strength in the U.S. today, but the way the industrial markets function, is it pretty kind of diverse across the regions? Or do you find that there are actually other regions of the world where it's more ripe for the opportunities?

It's reasonably diverse. I do think there's some interesting differences similar to what we have in our current core markets, where there are [ emissions ] leaders and new technology development and emission lagging geographies. We have a similar dynamic in water filtration, for example, depending on how advanced today the geography is in terms of that. So that's one piece. I do think our focus is predominantly in the U.S. as a starting point in large part because of the strengths we have here and building out from that strength. So one of the capabilities we think we could bring in industrial filtration space is taking something that's U.S. now and using our global footprint to extend, right? And so -- but I would see us focus largely in the U.S. in the near term.

There's a heavy amount of investor attention on M&A. How much of your attention is this getting? How much of an imperative does your team feel you got to get some deals done?

Yes. It's really important to me. I think one of the big challenges is you come out, you IPO a company, you separate and there's a lot of separation activity. And obviously, demonstrating our credibility as a new company and performing in our core has all been so important in the first year. And at the same time, it's been important to build a team with strong capability to start working our aspirations for the future for industrial filtration. So I guess the best way to describe it is this balance of short term and delivering what we know we need to do and build our credibility as a new company and being very clear that unlocking the future of industrial filtration is key to the long-term sustainable success. So increasingly now, I'm trying to put more of my time into the industrial filtration side because there's a large part of our organization that knows how to get on and do what we need to do in the core. And we're still building the blocks of how we're going to step into industrial filtration.

And then when you think about sort of a benchmarking exercise and you look across the competitive landscape and whether it's on the mobile side of the market or whether it's more on the industrial side of the market. But how are you thinking about where there are the biggest opportunities to narrow gaps versus the competition? What I mean growth is -- you've got your first-fit growth, aftermarket growth. Growth in industrial growth is very important. But is there anything from a margin perspective or R&D efficiency perspective that you see out there and like these are ways for the organization to get better?

Yes. So I think in our core markets, it's really become more and more apparent to me just how much opportunity we now have. We have a wonderful window here to realize growth in our core, and that's growth in top line and also expansion of margins. And so as I think about that and to try and simplify it there's 3 kind of levers I think about. One is making sure I get the capital allocation and investment to those outgrowth markets. So in our core markets, think India, think Latin America really making sure that we are winning there in those outgrowth markets. Overall, average market growth is sort of 2%, and that allows us to really lift that growth prospect. The second is really around what are we really pricing for value across our chain and how we realize that opportunity? And what more opportunity is there. And then the third is really and the market share opportunity for us is significant and vast. First is winning new first-fit business that then fuels the aftermarket with outgrowth customers that we haven't been able to or haven't prioritized in the past as we've been part of Cummins. And the second is really making sure we're getting more of our share in the aftermarket through many of the things I've already spoken about. So that's on the growth side that I really think we have a very clear opportunity to amplify our growth in our core. On the expansion of margin side, pricing obviously has a connection there and will flow-through. But we've also identified the transformation of supply chain, in particular, taking cost out associated with direct materials and automation that has the opportunity for further expansion of margins in the goal.

As recently as a year ago for having this conversation, I probably would have asked about electrification earlier. But just how much of your time do you spend thinking about it? What are you hearing from your customers? How do you consider it as you think about where you're investing dollars?

So we are very committed to a path towards 0 emissions, and we really believe as a company that we can be a leader in this space. We've got all of the toolkit to do that, right? We've got these great partnerships with leaders in the industry. We've got the technology capability. So we're at the table with those -- with Cummins and other leading OEs to discuss the solutions of the future that they need and how we can support them. And so really, I feel very good. Any change that comes about, it's like the IPO and the separation, I feel really good about any change that comes about because it allows us to seize the moment to win. Actually technology that we may have been locked out of in the past because of 60 years of development, we now have the opportunity to win. So as you think about hydrogen ICE and that is the technology coming forward, we have the opportunity to build about a platform and win into the future. So I think I'm quite excited about that side of it. In terms of the overall consequences for our business, I've said this all along. I do think it's going to be a long and messy transition. Even if you look at the scenario planning that played out from many of our OE partners from several years ago, most of the actual outcomes of electrification adoption are lower than their sort of low line scenario, right? So I think adoption is actually slower than what had originally been anticipated. But it will be a long and messy transition, and we are continuing to prioritize resources on winning through that transition.

Steph, I think that brings us to the end of our time. Thank you very much. Really appreciate it.

Thanks, Joe.