Cummins Inc. (CMI) Earnings Call Transcript & Summary

All right. Perfect. Thank you, everybody, for joining us. For those who don't know me, I'm Angel Castillo. I'm the Head of U.S. Machinery and Construction here at Morgan Stanley. And again, welcome to our 14th Laguna Conference here. So with me today, it's my pleasure to have James Hopkins, who was just recently named VP of Financial Planning, Capital Management and IR. So you've got a lot on your plate.

Yes. I love that you abbreviate the title.

Exactly. And then also Nick Arens, of course, with Investor Relations. So before we get started, just a quick disclaimer. For important disclosures, please see Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. And with that, again, gentlemen, thank you so much for joining us. Obviously, we've been getting a lot of questions about every aspect of your business, very topical in a lot of ways.

But maybe just to start out with the 2027, 2026 dynamic around trucks, right? The North American cycle, there's a lot happening there. So maybe the -- maybe starting at a little bit of a higher level, what are the customers telling you? What are you hearing in terms of what the emissions enforcement changes that has, kind of, been implemented by the EPA or that they proposed? What does that all mean? And what are you hearing customers tell you about how they're planning to use that?

Yes. We live in a complicated space right now, I think. So first of all, thank you for the invitation. Happy to be here, Angel, a great conference as always. So I appreciate that. As many of you know, Cummins participates very strongly in the North America truck market. So it's in medium-duty and heavy-duty. It's an area we've had a franchise for over 100 years, and we have some very good long-term trusted partnerships with OEMs. Generally, the market over the last year has been soft, but it's been improving, especially over the last 6 months and anticipated to continue improving throughout the end of this year. And that's really been driven by a couple of different things, as you mentioned. I'd say, one, we have seen a move to the upside of the general truck cycle. So fleets are generally making a little bit more money. And as we all know, that tends to drive more purchases of vehicles. On top of that, however, we have had this uncertainty around emissions regulations and product availability in 2027. And that's drove, I'd say, some externalities that have impacted the ordering patterns of many of the customers. So as we sit here today, we're, I'd say, privileged to have a little bit more certainty than we did a couple of months ago. And the primary reduction in uncertainty has been the EPA providing, let's say, semifinal rule, clarifying what the rules for powertrains will be in 2027. And essentially, what the EPA has stated is that they are providing the industry flexibility to both sell historic powertrains with an NCP or a nonconforming penalty or to move forward with new powertrains to hit the 35-milligram NOx rule. And that industry flexibility has led, I would say, to a lot of conversation across the industry about what demand patterns will look like in the second half of this year and into next year. As we sit here today, I'd say not much has fundamentally changed about those demand patterns because of the general strength of the fleets, demand remains high in the second half of this year. And also, given the fact that NCPs will kick in on January 1 next year and/or people will have the availability to buy new powertrains, there's going to be a significant increase in cost to the end user in 2027 regardless of what product you buy, which I think supports continued strong demand in the second half of 2026. Maybe that demand could be a little bit less than some people were estimating several months ago for those that were really worried about only having the option to buy new powertrains in their trucks. That risk is really off the table now. But fundamentally, I think the industry at this point is already capacity constrained, right? And so I don't think that's going to be particularly relevant in impacting the second half demand as we see it right now.

And what are customers -- to your point, what are customers telling you about the 2027 demand trajectory? I think the industry expectation is that you're now going to see a step change higher by continuation of the second half demand into 2027 versus previously, there was maybe an expectation of prebuy, then you fall off a cliff. What are customers telling you around that, to your point, especially since costs are going up regardless of which engine they're buying?

Yes, absolutely. I think the industry appreciates the flexibility that the EPA is providing on product availability. And so that likely leads to people purchasing more product than they would have otherwise. This is an industry that really values uptime. People buy trucks to make money. Uptime is key. And the industry is generally nervous about the manifestation of potential quality risks with new products. So the availability of current product, which generally across the industry is more reliable than it has ever been. I think will put their minds at ease. They'll probably buy more of those products. And importantly, I think as the industry starts selling some of the new technology into markets, that will also give the industry an option to buy some of that product, get comfortable with the technology. I think it will let the industry get through any teething problems with the technology. And so when the industry does fully transition to the new technology, the industry will have some experience with it, will be more comfortable with it. And so when that does happen, should have less of a cliff event in terms of demand than maybe we've had in prior cycles over the last 20 years or so.

Understood. That makes sense. And I do want to remind the audience, I forgot to mention at the beginning, but if you have any questions at any point, raise your hand, we'll get a mic to you. I want to make sure that everybody has a chance as well to get a question if they have one. But in the meantime, I just want to continue down that line. So, like, what is your strategy? What is Cummins' approach to this? I know you've talked about the phasing in of certain engines. Can you just, kind of, give us an overview of that strategy and also the implications of that on your financials? Because I think as we get all of these changes, there's been concerns that maybe there's now higher costs, but you don't get the price and therefore, more of a headwind to your margins. So if you could talk about, kind of, the impact on the financials as well as the strategy.

Yes, absolutely. I'll head off the first item where a lot of people are asking about NCPs and the ability to pass those on. We will fully pass on NCPs to the market. And so the average selling price of the historical product will go up. We will fully offset that with pricing. Profit dollars will be flat, percent will be down just due to the math involved. So I'll state that clearly before we move forward. I'd say the strategy of Cummins has always in this market been consistent. It's to produce the highest value to the end user through total cost of ownership. That's quality, that's fluid economy, both diesel and DEF. And it's having a product that also provides the best resale value in the market. And if we can do those things, it will drive the best market share in the industry, and it will drive profit both in the first-fit business and then in the aftermarket. And so our product strategy and the products that we will be launching over the next 18 months or so are a continuation of that product strategy. These are units that we've been working on for many, many years. They will provide better fluid economy to the customer base. They bring other new technological innovations that will improve the driver experience and also improve the profitability of end users. And with millions of miles on these vehicles and these powertrains, we expect to have a good quality launch that will be further bolstered by the more tactical strategy of starting production of these products at low volumes. And so we're excited to partner both with OEMs and end users to get these new products into people's hands in early 2027. These products will be connected to the grid. We'll be getting all of the quality data into the organization immediately, and we'll be able to iterate and get through any teething pains so that when we do fully transition to the new products, we expect the launch to be of a very high quality, which I think fundamentally is what fleets and end users are most interested in protecting their business model. So that's what we'll do. I'm also excited while we already have a very competitive position in North America in terms of our availability, these products will be available in more chassis with more OEMs on launch than even we have today, which is not an easy feat given our already strong position in the market.

So you indicated you will be passing on that NCP. What about the ability to get price on the new engine? To your point, you get a little bit of, I guess, a different strategy by different OEMs as to what approach you're going to take to rolling out the new engine and meeting the EPA27. Any risk to not being able to get that price for the value you're adding and ultimately deliver a margin-accretive product after that's fully rolled out?

We have a multi-decade history of being able to increase price and expand margin upon the launch of new, more complex technology to meet emissions regulations and to add value to the customer. And I don't anticipate this to be any different than those prior cycles. So there will be incremental price, there will be incremental margin. In the short run, you'll see some modest increase in some of the warranty accruals, which always happened when we launch new products. I would anticipate that to be moderated by the fact that we'll launch at low volumes versus a light switch event. But no, absolutely, we have decades of experience at doing this, and we always raise the price appropriately for the value we're providing and expand margins. That's the job of the business. That's what we're executing, and I'm confident we'll do that over the next 18 months.

That's very helpful. Again, if anyone has any questions, we have a question up here up front.

Dan van Doesburg, APG in the Netherlands. Maybe for not knowing Cummins so much in detail, but could you maybe elaborate on where you were 10 years ago and today and next in terms of your unique position in the OEM market in U.S. because for us, it's a bit of outsiders. So it's a bit difficult to understand how to value this whether it's a risk or opportunity and whether sort of the integrated OEM strategy of Daimler, Volvo, if their owners have to sort of commit to the integrated OEM truck market guys, engine producers or whether for Cummins, there's also an opportunity and how you struggle or even maybe can win over that proposition they can. So because that's the most difficult question for us, I think, to value your position in the U.S. market and abroad.

Yes. It's a great question and one that's been asked for the full 100 years of the history of the company. So Cummins is an independent manufacturer of engines and powertrain components, and we sell those into truck OEMs who all make their own powertrains. The value that we provide the OEMs and the reason they install us in their chassis are -- there are multiple different reasons. One, we tend to leverage scale, especially in subsegments where OEMs really don't have the scale to make the significant investments in powertrain. North American medium-duty truck is a really good example of that, of a market of, say, 130,000 units, it has multiple subsegments, which if all of the 4 or 5 known OEMs made their own engine in that space, it just is not economical. So Cummins can leverage that scale, provide a product to the industry that actually is less expensive than everybody doing it themselves. Secondarily, the value that we create to the industry is a technologically superior product and then a service and support network that is more robust than the alternatives. So if you buy a truck with a Cummins powertrain in it, you can take that truck to be serviced, the powertrain to be serviced, not only at that OEM dealer, but in any other OEM dealer because they can all fix the Cummins powertrain. So over the years, there have always been many questions about, isn't the biggest risk to Cummins that the OEMs will simply do more of their engines. What history has proven out is that today, Cummins has the highest customer pull, as we say it, in its entire history. Over 9 of 10 medium-duty engines in North America are Cummins, about 4 in 10 heavy-duty engines are Cummins. And as I said, as we launch these new products, we will be available in more chassis across OEMs, not less. So it's still something that we have to work on ensuring we maintain that value add that we maintain the relationships with OEMs and end users, but our competitive position and the utilization of our technology in North America has never been higher.

[indiscernible] On like the new model versus the [indiscernible] from Europe, and of course, high fuel prices...

Yes, a huge key of our engineering organization is to make sure that we have the best fluid economy, so both diesel and DEF. And I can't speak to what everybody else is launching here over the next 18 months, but that's a critical part of our engineering and the product portfolio that we need to execute. And I'd say history suggests we're quite competitive in there, and that's why we're in the position that we're in. And secondly, yes, resale value, especially in heavy-duty truck, North America, is very important. And so for a sustained period of time, you can sell a truck with a Cummins heavy-duty engine for a premium over a truck with a non-Cummins engine. And that's important for many of the large fleets because they sell that vehicle after 3 to 4 years. And given the genuinely razor-thin margins that they experience, the fact that a Cummins-powered truck can frankly be used in more applications, that premium that they're able to get in the resale market is a relevant part of their initial purchase decision.

Maybe just one last quick one, I guess, on that to tie it out with the truck side. One thing that's interesting is even in these new engines, even on the heavy-duty side, right, some of your partners have talked about this is the most, kind of, closely they've worked with Cummins in history. And I think one of the things you talked about at Investor Day was just the amount of content continuing to increase in these engines, even if it's a customer's engine. So what does that mean ultimately from a longer-term perspective for you, even if you don't have, for instance, the full engine, but you have more content in these products from a parts standpoint from an overall aftermarket?

Yes. No, I mean I would just say we have long-standing good relationships with the OEMs in North America, and we're able and willing to support them in different ways. And so we always want and desire to sell a full powertrain package to the OEMs. And we think that, that full powertrain package creates value to the end user. So we have a collection of engines, turbochargers, aftertreatments, axles, brakes, other components that as a system, we think we can maximize that system in a way that creates more value. However, there are instances where we don't sell that full powertrain. And we're more than happy to sell just the engine and the aftertreatment, maybe just the turbocharger, maybe just the axle. And so we will always look to partner with people and produce the entire system to support them and the end user. But when that doesn't manifest, we're more than happy to sell the component parts. And so that's been the strategy over a number of years. I think it's helped both Cummins grow and be profitable, but it's also helped our most important key partners grow their business and increase their profitability over time as well.

Very helpful. And I think it's a smaller part of your business, Power Systems, but it certainly gets a lot of focus with data centers. So I feel like people will be pissed if I leave less than 15 minutes for that. So maybe just, yes, stepping into that dynamic, right? Lots of happening in the news right now about whether it's slowing CapEx or slowing down the speed at which we're ultimately investing in this. Can you talk about your business in particular? I think we get a lot of questions, particularly on the diesel side and just the implications of new architecture in the world going forward. So maybe before we dive deeper into it, just what are you seeing from the demand side on the diesel backup engine? And if you could talk to the orders and the framework agreements that gives you visibility, that would be helpful.

Yes, I'll take that one. So I think fundamentally, to be as direct as we can, demand remains extremely strong. We announced in Q2 earnings, we just re-signed one of the large hyperscalers to a multiyear agreement and demand fundamentally remains extremely strong. With that being said, we do see the headlines that you guys are also reading, and we're actively monitoring those things. But fundamentally, if you look out to our order board, second half of '28 is where we're taking orders for our 95-liter solution. So demand is firm out to that. We're also seeing folks move down in displacement when they can't get a 95-liter, they're moving down to a 78-liter or a 60-liter or even a 50-liter solution. So if anything, the demand is extremely healthy. It is out multiple years. And fundamentally, probably the most important thing to communicate here is the targets that we outlined at our Analyst Day just a few months ago for 2030, $9 billion plus exposure to this space by 2030, we remain very confident in that, and that is largely underpinned by the diesel standby story. And I'm sure we'll get to it, but we're also excited about the other areas that we're participating in the data center space, which is the prime power space and also the battery energy storage solutions.

Yes, I definitely want to get to that because I think you've had a couple of very interesting announcements come out of that in the last few months. But maybe just one last one on the recip or diesel recip side. There's a lot of concerns around the amount of capacity that you're getting from players that are maybe a little bit further down in terms of the tiers, just the degree of competition that, that might bring, the degree of pressure in terms of the bidding activity. What are you seeing? Are these actual contenders when you're seeing bids for orders? Or just what does that capacity mean for your ability to sell and ability to get price?

Yes. So we're never dismissive of competition. But if you step back and frame the competitive landscape globally, there's only a handful of players that actually have the high-speed diesel reciprocating engine, high-horsepower engine technology to actually service this market. So you know who the players are. The second element is that we have established relationships in this space over decades. And those relationships fundamentally matter to these players. They know that what they're going to get from Cummins. They know who to call if they have an issue, and they know that we're going to support the product. And the third element there is our distribution presence globally. And that's extremely important when you think about these hyperscalers knowing that no matter where they're putting a data center, they've got capable people that can come out there and commission and install these units and then also support them if they need any support going forward. So fundamentally, we feel very well positioned. And we have multiyear framework agreements with these large hyperscalers. With that being said, there is a competitive pressure from these other parties that are trying to move into the space, where we've driven mid- to high single-digit pricing in the last few years. The ability to continue to drive incremental pricing is going to somewhat moderate, but we do still feel confident in favorable price cost through the end of the decade, and that was reflected in our 2030 targets that we outlined at Analyst Day.