Cummins Inc. (CMI) Earnings Call Transcript & Summary

All right. Thank you, everybody. Let's continue with our presenters. Happy to have Cummins with us. We have James Hopkins, you all know and love from Investor Relations; but also Brett Merritt, On-Highway business. I had a chance to spend some time with Brett, always insightful. We'll try to keep the questions as challenging as possible, but I know you're up to the task. So...

With that, I don't know if, James, or you, Brett, want to kind of give the lay of the land. Obviously, the obligatory question about coronavirus impact, if you want to address that now, or if you have anything else you'd like to open with. But I'll let you kick it off.

Yes. So why don't I just talk about the coronavirus, and then maybe Brett can talk a little bit about some of his market. So I think as you're aware, when we gave our guidance back at the beginning of February, we didn't include any impact of the coronavirus at the time. Things were still moving pretty rapidly, a pretty fluid situation. What we've seen right now, we have about 10 facilities in Hubei province in China, many more dotted throughout the rest of the country. In general, our facilities open 1 to 4 weeks after the Lunar New Year. So a delay on opening there. And our total China exposure on consolidated sales is about $40 million to $50 million a week. In addition to that, our JV income is about $200 million a year in China. So definitely had some negative impacts on domestic China consumption given the delays in start-up of our facilities. Almost all of the facilities now are up and running to some degree. Some of them 100%, some less than that. And I'd say the ones that are running a little less than that, it's really driven at this point by OEM partners whose facilities aren't up and running 100%. So we'll know a little bit more about what the full year impact is, the demand, I think, by the time we get to Q1 earnings. Just need to see to what extent potentially the government does some stimulus and whether the demand that we did lose in the first quarter comes back in the second half of the year.

The impacts you spoke of obviously on the ground in China, the amount of exports out of those facilities to rest of Asia, Europe or North America, can you enlighten us?

Yes. So from a finished Cummins product perspective, we do not export a significant amount of material outside of China. We generally produce and sell in country. The area that we're paying very close attention to is more some of our Tier 2 and Tier 3 suppliers that have some of their facilities out in China that export some of those to our global facilities. So at this point, we've had no disruption, 20 of our facilities related to that. But certainly a very concerted effort by our supply chain organization tracking individual part numbers and understanding where the risks could be in the supply chain related to some of the delays of those Tier 2 or 3 suppliers that have been ramping up production.

Could you help us a bit with where that risk is most acute? Is it on-highway or off-highway?

Broadly, it's going to be in all of the different end markets.

It'll be across both. So where we can -- where we have dual sourcing, we switched to the other source. But there are some components that -- this is the manufacturing base of China, and there's some base electronic components that affect many products that are made there. And we're tracking it one by one multiple times per day. And like James said, no interruptions to date, but we have to cautiously watch it. And it will -- we will incur some premium freight undoubtedly due to...

The alternative suppliers that you've reached out to, was that something very proactive? Or these Tier 2, Tier 3 suppliers were already shorting product?

Already approved.

No. I meant -- but they were already shorting you product. You had to make the switch. Or...

Proactive.

It was proactive, okay.

Yes.

And are you taking the opportunity with that supply still there just given the issue? Obviously, it's spreading globally. Are you proactively taking on some extra inventory to make sure you have it for serving demand a month or 2, 3 months, whenever the current channel inventory fades? Or are you not...

We're just trying to balance it. I would say we're not doing a mass build ahead, but we will be cautious. So...

Okay. Any further coronavirus question? Okay. Let's move on from coronavirus.

Good. We'll know a lot more on the 1.5 months at the analyst call. Hopefully, that does settle a little.

Sure. And we're obviously speaking without knowing the potential demand impact in the North American market. But when you think of the on-highway market in North America, you know where your production has been versus retail. You have some sense of your big OE's build schedules. Have you seen any change and how they've thought about how the cadence of the year has played out in the last few weeks, last few months? Any notable change on -- third quarter is probably about as bad as it gets on a year-over-year basis for the OE. Maybe for you, it's a little earlier maybe, a little bit. Is that still the right way to think about it? Or any sort of nuances?

Yes. I think so. We would call probably third quarter is about as -- third or fourth quarter would be as bad as it gets. I do know that we've been a bit more bearish on the number than many are conservative. We have felt the build shift between Q2 of last year and Q1 of this year. For sure, it's a 30% shift down in build. We're cautiously watching the market, particularly the inventory number of trucks to identify if other build shifts will happen. So I think that's, for us, the number we're watching right now. And we think we're fairly accurate at our market forecast to 40% down.

And how would you flex your costs down? I know Jamestown, as we talked, didn't hire a permanent employee after 2018, I guess, was the right year. I think that your ability to flex down, if there was another way down, is this now getting to a cut-bone decision? Or even to get to this level, it was all just temp and there's even more temps to go? If -- I'm just trying to get a sense of decrementals if -- obviously, if demand did get impacted by the virus, what is the Jamestown at this lower level of production? What are the decrementals like if there's another 20% decline?

Yes, it's fair. We'd be prepared. I mean we're still not at a -- we're still building 315 ex 15 today at Jamestown.

So what's the peak?

It was a peak at maybe 450, short time of capacity. And Jamestown at one point was capacitized at 340. So we know how to operate down, and we have rings of defense mechanisms is what we would call it, that we know what the next stages that would take. And this plant is particularly good at doing it, whereby they'll even do voluntary leave of their own because they've worked the last 2 years for every day. So some people are ready for a bit of a break, and we have a series of probably 2 more levels down a week ago.

The decrementals from 315 down to 270, better or worse than 450 down or 315. Just trying to get a sense. People are trying to feel, can we bottom out North America truck if something like this is the thing that can make you feel like, "oh, we can go lower."

Yes. I mean I think as we've communicated in the past, we really target company decrementals. And so the guidance -- the midpoint of the guidance is 25% decrementals, excluding the new power business, committed to that at the current volumes. To your question, if things were to deteriorate materially further from here, we'd need to look at that again. So there is some period where you don't have to do -- we're doing 25% decrementals. I mean you have to maybe cut too far into research. And we've communicated in the past that investing through the cycle and research and development is what sets us up for success and outgrow for the future. So we wouldn't want to be doing anything on the investment side that would negatively impact the future growth of the company just to protect a short period of the P&L.

So not to put words in your mouth, but unless you want to cut bone, the next level of decrementals could be a little more problematic. There’s less variable cost.

It depends on the [ level ]. So like I said, 8% to 12% down is the revenue guidance now. The midpoint of that guidance is at 25%. We've executed that in the past. That's our intent this year, given kind of what we know today.

Off-highway, the power gen markets in particular, given they're a little later cycle on the construction cycle, just curious, what visibility do you have in that business? And that business now houses more than its power gen, I think, the way the business was reconfigured a couple of years ago. But can you give us some insight on the visibility on a revenue basis for the rest of the year on that business? How far out is there comfort on that revenue number?

Yes. I would say it differs a little by the different end markets within that power segment business. So as you mentioned, we've got power generation. The larger the size of the power generation equipment, generally, the lead times and kind of visibility is a little bit higher. Then you get into oil and gas engines to support fracking or mining, engines to put in new mine trucks, and the lead times there would be more similar to some of our on-highway lead times. So depending on the end market, a little bit different. As we look around the world today, depending on the region, what you said, power gen demand down maybe 5% to 10% depending on region. No new news on that today. Outside of maybe China, we'll be a little bit worse as we kind of mentioned before. In the oil and gas mining, kind of those more resource industries, I would say over the last 3 months as each forecast cycle comes in, there is a little bit of incremental weakness there just given some of the dynamics in that market. And that weakness, not only in orders for new engines but also seeing some additional weakness in the aftermarket, the parts and service side as some of those end industries really look to conserve cash.

Bigger picture question about on-highway. I'll let you answer it any way you want. But the level of investment that Cummins is making to address pretty significant shift to whatever you think the stop gap is, from gas to battery to hydrogen fuel cell. There's a lot going on, and you have your hands in a variety of markets. You see the level of investment that auto companies have had to make to get to electrification. Your number sure feels low. So help us understand the efficiency of already institutionalized knowledge versus just you’re just being efficient. The numbers does feel low. And then also maybe give us a sense of when you look at a Meritor relationship with PACCAR and EV, kind of where do you see Cummins' role in a couple of years? And I assume that's coloring where you're investing those dollars.

Yes. Sure. So you've heard us say this before, we definitely believe in the power of choice. So we don't believe that there's a silver bullet for on-highway. So we think there are particular applications that work well with EV, and we're already operating with some today, such as transit bus and a lot of return to base applications. We are investing. But by the way, likewise, with fuel cell, we would say that is potentially more applicable to, say, heavy-duty line haul truck, which electric doesn't really address very well in an ongoing situation due to the range and charging infrastructure needed. So we continue to invest in both. We would say that our level of investment is appropriate. We equated a little bit to what we did in the emission standards over the past 15 years, which we are not the company that makes the filter, the catalyst, all the precious metal. But we have invested enough in the research to be really, really good buyers and maybe prescribers of what should -- which should go on to it. So we're doing that same thing on battery pack and battery pack management, which we think are differentiators. But we're not going to make the battery cell itself, which is a little bit different than the investment scale you see of a Daimler or someone on the passenger car side. We also do not think that, that base technology scales up exactly for commercial vehicle and that there is different battery pack management and control that needs to be done on that side. Probably the third major point is while there are some early wins in kind of the stage 1 or 2 technology, we very much on purpose want to wait to the stage 3 that actually becomes commercialization of it. So the couple hundred or the [ fifty ], while interesting and good, we're already getting that research. We would rather go for the longer term. And I think both in bus, school bus and in truck, you'll see Cummins have a large presence, not only due to the technology but we've also invested in the 3,300 locations that are in every single municipality. And so we think those that trust us or the market trusts us that we'll be there, and not only there but in their garage, and that's a huge differentiator.

The power of choice obviously still makes you feel like you have your hands in a wide variety of solutions. So I appreciate being a wise purchaser. But still, again, the number feels still a little low. Can you educate us a bit on where that money is going just so we get a sense of how efficient that must be? Because again the number in absolute terms seems on the low side.

So I won't go into the exact money of the R&D but where it's going, probably, there's more than this in programs. But I'll just explain it in 2 primary parts. One is the pure electronic power for bus and truck, and this is new battery pack built around commonized cells for what will be, we've called it, our stage 3 technology for commercialization. And it'll be unique between bus and truck, but we have a full new -- our new product development program to deliver that. The second part you'll see a fair amount of work is the electrification of a diesel engine. And so as we look at future emission standards, you will need the hybridization, not a hybrid that you know today that operates in New York City buses but a more hybridized where you capture energy off the truck, utilize it in battery to either address a NOx emission standard and/or CO2 for the future. And so I think you'll see us invest in those 2 areas. Specifically, I don't think we've gone in more depth to say this is the precise amount of money other than calling out the $150 million per year.

Anybody in the audience have a question? How do you look at '21 base case right now for the North American truck cycle?

That's an interesting question. So we definitely don't call out the market. What I would say is historically -- and thanks for inviting me back during the bad part of the market since I was here during the good part of the market...

You're welcome.

Now it's the terrible downturn. So -- but that's what I deserve. So historically, this has lasted kind of 4 to 6 quarters. And so you would like to say there is some optimism regarding -- this is heavy duty, that could there be a return if you think of Q3, at least half of it, Q4 was down and then potentially the entirety of 2020. So would there be a return in heavy-duty truck? I think a few things have to play out. The balance of the production that the backlog has been coming down that has not been put in inventory. So right now we still need to clear a fair amount of truck inventory through the system. If that happens and the large people, the top 63 that represent 33% of the market, if they say I'm going to buy and in a big way, I think you'll see the market return. If they wait and see pending election or a variety of other things, then 2021 could be a mixed year, again, which we've had this before. So we're operating, looking at the same measures you do of production, backlog, inventory and what's the daily sales rate. But anecdotally, when I was out, I've been with maybe 3 or 4 of the largest fleets in the last year. They would definitely see 2020 where we are and they would say, once the truck people start making money again, we'll buy more trucks. And so I think we have to wait for that. Medium duty would be a different story. We see that historically much more flat, and I would have to think that you'll see some positive movement off of this year and 2021 for medium duty. I don't know if you have anything to add?

No.

No? Happy [indiscernible] 2021.

Yes. The implications of -- a question in the audience? Sure, go ahead.

So I heard from a Street analyst that you've been in conversations with a European OEM about constructing their diesel engines so the OEM can invest more in its electrification efforts. Is that true? And if so, can you like shed more detail around what that would look like?

Sure. What I'll say is it's conjecture or rumors as far as being with a European truck OEM. But what I will say is -- I think we covered this a bit at our Analyst Day. The base idea that truck OEMs have a lot of pressure on them is absolutely true. If you look at connectivity of all trucks, safety systems, reinvestment on the chassis in every single market for greenhouse gas, for comfort, for a variety of things and to integrate safety systems and then a wide variety of powertrains we just went through that everybody thinks no one's investing enough in, this is a huge crunch on the research and engineering budgets of many OEMs throughout the world. And so we subscribe to the hypothesis that scale wins, and that only via scale will you be able to continue to invest in diesel and natural gas, which will be the primary power choices for the foreseeable future. And so we think we offer a great scale that we could have a conversation with a variety of OEMS, and we do have these types of conversations over the years. What I would say is I think there are opportunities for us to do things like that, that we're a safe risk mitigator for many OEMS if they're going to invest in many things. Why don't I trust Cummins to deliver this part of the engine? You're seeing that play out at a micro level in small regions, where some OEMs can't invest as much. You've seen it right now in India as we released BS VI. We feel incredibly confident with our technology. I think you'll see many of our components across a wide variety of the OEM landscape. And I think all of those OEMs won't be able to invest in every product niche. Therefore, they'll come to us for those niches. And that will come out over this next year. But then you can see it at a mega scale too. If someone is talking about where they're going to put their investment and they know they can get a really competitive technology meeting future emission standards at a high level of quality and the ability to serve, we think we provide a good option for many of those types of OEMs.

Along the same lines, the obligatory trade Navistar question. Proceed.

Both are good friends of ours. So what -- I think I've talked maybe in here with different people. We know all of these companies really well. We meet obviously with Navistar daily. We meet quite often with MAN and Scania, who make up TRATON. And Scania, we've long had a joint venture on the fuel system side for over 20 years. We now sell them medium-duty engines in Europe and Brazil. And then we've been serving as a good supplier and partner to MAN in Latin America in medium-duty engines for over 30 years since the early -- since the mid-'80s. And so we have relationships across the board. We think a stronger Navistar is strong for the market and, therefore, for Cummins because we want the pull of Cummins engines through all markets. And we welcome TRATON, obviously, who's put an offer in coming and being a partner, and we think there's plenty of space for Cummins to provide our differentiated offerings through TRATON just as easy as we could at Navistar.

The question about some OEMs and putting their focus on alternative drivetrains and maybe you take a step in for the next stage of their diesel development. Obviously, your greatest strength is the 15-liter, at least differentiated strength, I would say. Just to give some insight, are they looking downsized as well? I mean you’ve already dominated 15-liter. There aren't that many players have a lot of 15-liter themselves. But just give us some sense of scope.

No. I think you could look across the scape -- the landscape. I mean if you think if you subscribe to our hypothesis of scale winnings, medium duty, I mean, we have unparalleled scale. We make over 600,000 to 700,000 medium-duty engines globally. Nice market share in North America. And it's a tough market that is not large. It is a niche. And you have to provide -- the medium-duty market, we just say it's medium-duty truck, there's about 30 different applications. And so the ability to hit that with a technology that also hits low cost, highly durable, highly reliable is not an easy product. And so we would say areas like that would be excellent areas to scale, and we could help. It's what we do in some of our partnerships in India and China as well.

So your ability to provide that scale, medium duty, is your greatest strength.

It's a good area and the 15-liter would be obviously another node. Then you'd look at a variety of products out of China where we could provide some pretty large scale in a 12- or 13-liter platform.

Your comment about India, I mean, you already were so large on Tata to begin with. And you said you're taking incremental share, and you already have most of all of Tata. Are these incremental wins within Tata? Or is this -- are these other OEMs with Bharat next engines?

I think you'll see even other OEMs of the future by hitting niches in products. That's our strategic plan. Nothing to announce. And we'll continue to push that way. Ultimately, we want in all markets, like we do in Australia, like we do in Brazil, like we do in the U.S., to offer a product through an OEM for the end customer to have a choice. We'd love that end customer then to pull that product through the OEM, and this is the push/pull we talked about in our strategy. We're committed to that, and we think it could work in India. It already works in China and how do we bring that strategy to fruition.

There'll be a mic coming. One second. Thank you.

When you talk about medium duty, that's not heavy duty, right? So it's not the XL12 (sic) [ X12 ] that you make? Or is it?

We do make an X12. That would be mid or heavy duty. But the -- no, I was particularly talking about the B6.7 and the L9 engine, which is in the 6 to 9 liters.

So in that 12-, 13-liter range, you talked about how you're dominating 15. Do you make a lot of those now?

No.

We don't.

We'd love to make more.

Okay. So if a European were to come along and say, build our engine, they wouldn't be buying 15s, right?

It depends where we're talking about, right? All the Europeans buy the 15 from us in the United States or in Australia...

Or in North America.

Or Australia is the other usage. We bring the X12 in North America, which may or may not be what we're talking about. We'll sell about 5,000 this year. It will launch with Daimler in July, freightliner in the Cascadia as well as their vocational trucks. It will be with Autocar. It will be with MCI and Bus and some other smaller OEMs. And the differentiation there is there are some scalable 13 liters already in North America. We don't need to come in with a me-too product. We believe if the end user is buying for fuel economy and duty cycle, you should choose the 15 liter, which not only exceeds in greenhouse gas but also has a better resale value than any 13 liter out there, and you can look at those public resale numbers up. But if you're coming for a weight application where you get paid by the pound, so a lot of these applications, they get paid by how much they put on, you can deliver that with an X12, which is about 800 to 1,000 pounds lighter than any other powertrain in the market. So you get paid 1,000 more pounds for every haul you make. So we're trying to differentiate around it and not necessarily come right after the 13 liter. If someone wants a 13 liter for each of their haul, they should use one of our partners who hopefully have Cummins components on.

Can you update us on the EPA issues? A, what the testing of the miles per gallon on the pickup truck and then the bigger, broader issue of the older engines staying compliant from, I guess, 2012 family? You're -- just any update at all without getting in trouble with the EPA. James smiles over there.

So a couple of years, we had the $368 million charge related to some older 2010 through 2015 vintage engines in the United States. So that charge was booked a couple of years ago. We're progressing through kind of our warranty process and replacing aftertreatments. And we're mostly done, I'd say, with the heavy-duty side of that and just kind of started the medium-duty truck side of that this year. So that's fully accreted for, and the cash has been going out the door as we finish those repairs. In relation to the issue that we kind of first talked about, about a year ago related to emission certifications on the Dodge Ram pickup truck applications, we have no new information or anything to share on that other than the pretty consistent statements we've now made for about the last year, both in Tom's earnings script and then in the Ks and the Qs. So working with the appropriate regulatory agencies, trying to get through that as expeditiously as possible. But at this point, no additional information to share. We do have our current 2020 now, model year Dodge Ram. All the certifications and calibrations are all agreed with the EPA and CARB going forward and have been now for about 5 months.

The earlier comments about the heavies, are we saying that accrual covers all the risk that you're aware of? Or -- so you think we are down solely to the Dodge Ram pre-2020 family issue. I just want to make sure we don't walk away too comfortably here. There's no issue with the old engines staying compliant beyond...

The specific issue that came up 2 years ago, that accrual of $368 million is our full estimate for the accrual to deal with those issues, and that's essentially hardware replacement. There are certain assumptions within that calculation, but we feel comfortable with that assumption at this point.

Yes. The only ones left, there are some medium-duty trucks that are having the emission systems replaced even through this year, but it's already accrued for us matching the estimates.

Your balance sheet. I appreciate the spending on the cash flow. But the balance sheet, the leverage is very low. How should we think about, as technology evolves, needs that maybe you have in your business on-highway versus people who think of it as maybe off-highway or who knows where Tom could go with it? A, are you a part of those conversations? And give me a hint if it's on-highway or off-highway if you're looking about – just anything about it?

It's the same 3 that Tom has kind of talked about. And definitely, if it's an on-highway, we’re a part of the conversation. There's not always, if it's an off-highway, we’re not a part of the conversations, that don't need to be. But I think for the right accretive buy, we are willing to obviously use the balance sheet, but we need to see that it's going to give the same shareholder returns as what we expect. And so we've made some minor investments that you would call them minor investments in some new power areas. And I think the other 2 areas we would look is, is there something in the on-highway space or is the large engine space, I think, are the 2 that are defined. We continue to assess, but I don't think there's anything to announce.

Can you help us with a guessing game a little bit of -- we know the big bore engines that's off-highway is fine. But when you look at where technology is going on the drivetrain, where the devices that maybe used to be dumb devices are now going to be smart devices. What's your view of what's evolved from -- we are an engine company, so now we need to have the transmission for better efficiency and emissions to fill in the blank. But what's evolved over the last few years and what you see coming that would be something like, I never thought they would buy that, but they're looking at that component on the truck a lot differently than 10 years ago?

I think it's no different than what many people in here would think about. So we continue to look at it. I try -- and I mean obviously my focus on the on-highway business is grow the transmission business and engine business as much as possible, and we're doing that. We'll continue to do it. If there are other tack on that help us either via technology, partner space or market space, I think we're open, and we're looking. So no hints.

Well, that was unsatisfying. Any questions from the audience? Well, I'll follow-up with that though. How committed are we? I know it's about price and asset available. Is it fair to say that we should not expect a sizable share repurchase of any kind? Because there's so much evolving in your industries. I mean everybody always thinks about timing of -- wait until the next recession, get something cheaper. But I think for you guys, regardless of economic cycle, there's just a lot of issues coming at you from across on- and off-highway. While share repo could be attractive, you probably have even more reason to sit a little bit and get a lay of the land in the next couple of years for how technology unfolds. Is that fair?

I mean I think that we continue to produce a significant amount of cash even this year and a down year. And so this year, we've provided the same guidance as last year, 75% of operating cash will return through dividends and share repurchase, which is essentially equal to 100% of free cash flow. And we retain that very strong balance sheet, which gives us flexibility in a number of different ways. But I think that flexibility is even more important today given the changing technology environment and the need, even greater need than ever before to be able to maintain research and investments through cycles, et cetera. So that balance sheet provides us the opportunity to do that and the flexibility to move quickly when and if we need to do so.

So commitment to cash flow, repo and dividend. But balance sheet, sort of to be utilized when the need really arises.

Yes.

Yes.

Okay. Any last question before we wrap up? All right. Well, thank you very much. I appreciate taking the time.

Thank you.

Thank you.