Cummins Inc. (CMI) Earnings Call Transcript & Summary

Okay. Good morning. Welcome to the kickoff of the UBS Global Industrials and Transportation Conference. I'm Steve Fisher, UBS machinery and engineering construction analyst. We are very pleased to have Cummins lead us off here today. We have James Hopkins, Executive Director of Investor Relations. If anyone has any questions for the discussion as we go through it, please submit them through the website app, and they will come directly to me. Before we get started, as a research analyst, I'm required to provide certain disclosures relating to the nature of my own relationship and that of UBS with any company on which I express a view on this call today. These disclosures are available at www.ubs.com/disclosures. Alternatively, please reach out to me, and I can provide them to you after the call. So with that, James, it's great to have you here.

Maybe just to start off, can you give us any more sense of where we are with the manufacturing operations, what's the status of manufacturing restarts, how smooth it's going and any more confidence about April being the bottom?

Yes. Just want to start by saying thanks for the invitation, Steve. Really happy to be participating in the event this year. I think we've talked a little bit about the challenges that we faced, broadly speaking, in April both within the supply chain, our own facilities and then OEMs as well. So at its peak in April, we had -- roughly 70% of our global customers were completely shut down. As we stand here today, essentially all customers are back open. It kind of was a slow but sure improvement in the percentage of folks that were shut down in May. But while most of those OEMs are now back open, they, generally speaking, are seeing relatively slow ramp-ups in production. I think that's primarily due to ensuring the supply chain is able to provide the parts and that facilities aren't kind of shut down due to part shortages. So I think we have pretty good confidence that April will be the most challenging month for us of the year, but that's really due to OEM shutdowns, so a pretty low bar, improvement into May and then into June. And then as we look at the second half of the year, we would expect production to be less determined by some of these supply chain challenges we're seeing now in the industry and really more related to fundamental demand, which, of course, remains relatively unclear given the economic backdrop.

That's helpful. And I think you guys have talked a little bit about, as you've gotten manufacturing operations back up and running, there -- clearly, every company needs to have some incremental COVID-19 safety protocols. How would you describe the protocols that you guys have implemented in your operations? And what's the impact on efficiency levels? And can you make up for any of those inefficiencies that it brings?

Yes. Good question. As with all companies, our #1 priority right now is keeping people safe. And so as you referenced, we certainly made changes not only in our manufacturing facilities but also our distribution facilities, technical centers and even offices. Kind of specific to the manufacturing facilities, a lot of the work there has been related to ensuring that we have the appropriate level of social distancing. And we have, in order to accomplish that, in some cases, adjusted workstations and, even in some instances, adjusted shift patterns as appropriate. We've also developed some kind of back-to-work playbooks and ensuring access to PP&E (sic) [ PPE ] for all of our employees each day as they go to the workplace. Having said that, from an efficiency perspective, Steve, around 15% of our cost of goods sold is really people costs. And so while we may see some impact to efficiency in the short run related to this, I would say, given the pretty low volumes that the industry is experiencing today and the proportion of our cost structure that's really related to labor, I wouldn't expect that to really move the needle in any meaningful way from a P&L perspective. And then, of course, hopefully, as we look forward further into the future when demand does return, we'll certainly make additional improvements in the way that we manage social distancing and other aspects of the situation and would look to have the same level of efficiency as we did before the crisis began.

It seemed like in some ways, in talking to various companies, that the first go around here is really kind of experimental, kind of running multiple shifts and seeing how you can make it work and then those -- that process will get smoothed out over time. Is that kind of the way you're viewing it?

Yes, I think it really is. And so this is certainly a unique circumstance for all of our different plants that are going through this, for our Distribution business where, of course, we have technicians that are out in the field fixing product and servicing product. So it's certainly going to be a learning experience. There's a lot of emphasis on this internally at the company kind of, as I said, to ensure the safety of employees. And I think given Cummins' core competencies in engineering, innovation and kind of creativity in some ways, I think we're leveraging all of those key capabilities to both ensure the safety of our people while also making sure that we're kind of supporting our customers and keeping efficiency levels up.

And one thing you mentioned was about shift patterns, and we've heard about some companies adding on extra shifts just to reduce the number of people involved. Is that something that should really be considered short-term protocol? I think that maybe that might be one of the more inefficient approaches to it even though more effective on the distancing. But how do we think about the shift patterns as part of that process?

Yes. I think time will tell, Steve. As we look at that and we've had limited instances where we've tinkered around with that specifically, it's not been something that's really resulted in incremental head count or hours, really more around ensuring there's fewer people in a building and allowing a little bit more social distancing on an assembly line versus anything else. So again, we'll see, but I'm sure, over time, we as well as the rest of people in different industries will come up with creative solutions and come up with the best solution here for the safety of our employees.

Got it. And throughout the Q1 earnings season, we heard a lot about the concerns from a variety of companies in the sector about the second- and third-tier suppliers. Where do we stand on the supply chain? You mentioned that's one of the factors going forward. Where do we stand on that supply chain and their ability to kind of get back ramping up?

Yes. Certainly, it was an area of challenge for the industry, I would say, in May. And a couple of specific regions, I would say, were kind of popping up, let's say, on the radar more than others, and those 2 being India and Mexico. In both instances there, essentially, the COVID shutdown was a little bit more severe than we saw in other areas of the world, and in most instances, all manufacturing shut down across both of those countries. So India really impacting more local/domestic production, whereas Mexico, really a critical part of the North America supply chain for many industries, including our own. And so what we had seen, I'd say, in probably the first half and second half even of May, as we were seeing facilities across the industry ramp up in the United States, we were not necessarily seeing the same thing happen in Mexico. And so that was causing some concern on the ability of the industry to produce in the United States in the reopened facilities. There's been a lot of work that's kind of gone on across the industry to get Mexico up and running as soon as it's been safe to do so, and the industry is slowly ramping up production in North America primarily due to some of those challenges we're seeing on the supply chain side for Mexico. Still some bumps, I think you're still seeing some of that even today and are likely to see that continue probably through the end of the second quarter. But hopefully, as we get to the end of the second quarter, everything will be really open, the supply chain will be somewhat normalized and production rates will be determined more by end-user demand than some of the supply chain constraints that we really see today. So that's kind of our hope. We'll kind of see what the next 30 days brings, but we've certainly seen improvement even over the last week or 2 on the supply chain side really from Mexico.

That's great. As you think about the longer-term here with the supply chain challenges that have emerged even before COVID, what do you guys think about how things might change over the long term? Is there going to be just an increased domestification of manufacturing or producing or having more redundancy in the supply chain where the major manufacturing is? Or how do you think the longer term will play out on the supply chain?

Yes. I think that it could play out in a couple of different ways, Steve. So just from a -- I'll talk more about Cummins' perspective and then maybe reference the industry. For us, the vast, vast majority of our Tier 1, Tier 2 suppliers for products that's sold in North America are within North America. There's pretty stringent NAFTA content rules within the truck markets here in North America, and so most of the stuff is coming from the North America region. Then for us, to the extent there are portions of the Tier 1 and 2 supply chain that come from outside of North America, the #1 region for us is actually Europe, #2 is actually India and China is a distant third. So the exposure maybe on the supply chain side is a little bit different than people anticipate, but that's actually where it stands today. Generally speaking, those parts that we're getting from outside of North America are going to be a little bit more technically special or unique. And so certain portions of the supply chain maybe have 1 region or 1 source globally that helps produce that. And then in some other instances, you have maybe lower tech product. Forging is a good example where there's just not many places within North America you can kind of get some of those products, so maybe those came from an India or a China. So it's very much a regional supply chain model for us today. I think we continue to look at that on a daily basis, understand if there's things we want to change over time. I think given what we know today, we're not expecting any wholesale changes in that regard. But we have a supply chain capability that spreads the globe, and so to the extent we need to adjust things over time, I think we're very well positioned to do that. But as we sit here today, not actively looking to do that and feel pretty well positioned in terms of our supply chain in North America really being the dominant region for things that we actually make in North America, not a lot of imports going on.

Got it. We did get one question coming in here, and that relates to something you were just talking about a minute or 2 ago about the rest of the year kind of playing out. And the question is, if you guys will have -- if you think you'll have enough information on the supply chain and more steady production schedules from the OEMs by, say, the end of June, that will allow you to offer a second half or full year guidance for 2020. Or do you think there are still going to be too much uncertainty at that point?

I think from an Investor Relations perspective, my preference is always to give guidance. I think sometimes, we receive feedback that we give too much end market guidance here at Cummins. I don't think it's a bad thing. It's my preference. So we will certainly look to provide as much feedback from our management team on our expectations for the remainder of the year. Whether that manifests in revenue and profit or more qualitative view of things, I can't say here today. What I will say though is, hopefully, as we go through the next 30 and 60 days and all of these OEMs are up and running, we are up and running, the supply chain is starting to normalize, I think that provides us a much better opportunity to provide investors with a better outlook for the rest of the year than the position that everybody found themselves in at the end of April where the level of uncertainty was just so high that I think providing specific numbers to The Street really wasn't going to be massively helpful to investors just given the potential wide range of outcomes we would have had to discuss. So hopefully, I think we'll be able to provide something. I think that as we go forward over the next month, couple of months, certainly, clarity is increasing. But there'll still be more uncertainty than we would normally see in a standard market.

Got it. You mentioned shifting from when the supply chain gets back up to shifting the focus on demand. How are you thinking about the backlog at your customers? And to the extent that you have them yourselves, how do we think -- there should be some visibility to the backlog. How much visibility is there? How long will those extend? And at what point do we really need to start to see those backlogs being rebuilt?

Yes. So the backlog, specifically, I'll talk a little bit here about heavy-duty trucks, Steve. It declines obviously from pretty peaky levels here 1.5 years ago to where we stand today, which it's not at particularly healthy levels. I think one of the things that we continue to look at very closely are monthly orders and then movement of that backlog, especially in the short run. And so for example, last month, while net orders were kind of positive in the mid-single digits, there were more than -- or roughly about 10,000 units within the existing backlog where delivery dates were pushed out more than 12 months into the future. And so those didn't count as cancellations, but for all intents and purposes, that's 10,000 units of an already pretty challenged backlog that's 12 months out or more into the future. So I think we'll look at orders, but we'll also look a little bit more deeply than just kind of the headline number just to understand if it looks like fleets and other purchases are trying to move out some of those orders that they've already made so that the actual backlog in terms of what can be produced over the next 3, 6 months maybe is not as high as the headline numbers might suggest. So that will be something we can continue to focus on as we go through and work with our partners to manage through that. But certainly, the backlog is not at the levels that gives us confidence for high production rates or significant improvement in production rates in the short or medium term.

Got it. We did get another question here related to China heavy-duty truck, and maybe we'll work into that as we start to talk about some of the end markets and the regions over the next minute or 2. And maybe just thinking about Cummins clearly has a breadth of end markets and regions. What would you say -- which end markets do you think are likely to come back the quickest and which are likely to take a bit longer? And a similar question on regions. Which ones do you think are likely to come back the quickest and which ones might take a little longer?

Yes. So I would say, historically, the truck markets generally tend to be a little bit more early cycle and perhaps bounce back a little bit more quickly than some of our other end markets. So we live in a relatively unique time period. So whether that's the case or not through this cycle, unclear, but historically, we would tend to see that in the truck market. And I think one of the key questions as I talk to investors and people within the industry is just trying to understand as we go through this challenging COVID situation, whether in North America that is going to extend the length of the down cycle here or simply make the trough a little bit lower than we would normally see. I don't think there's really kind of consensus around that today, but obviously, as you look at different industry expectations for 2020, production in North America is going to be exceptionally weak, levels of production that we haven't seen in several decades. So I think that's something we'll continue to monitor to try and really understand is it the same length of cycle just deeper or does the cycle get extended. But fundamentally, whether it's the United States, Europe, China or India, generally, the truck markets bounce back. As we look to some other end markets, the ones that rely a little bit more on corporate CapEx or maybe overall nonresidential construction, I'm thinking about our overall construction business, maybe more our power generation business and mining, those can tend to take a little bit longer to come back after we see demand come down. So we'll see, again, if that happens this time, but those are really going to be driven by a little bit the macro and what some of the people in those industries do with their capital budgets. And so to the extent that they're cutting those back and then the investment profiles in their mining space come down, that could negatively impact those markets for some time. So we'll see how kind of the 2 play out, but generally, I'd say truck comes back first and some of those other markets maybe take a little bit longer to get back to prior levels. Region-wise, I think that you probably will see some differentiation between regions. So China clearly has come back very, very strongly here in the second quarter. Our production of engines were at record levels in April, and that kind of run rate continued through May for us. And so we were not expecting that to continue into the second half of the year. I think at this point, the production that's occurred in China in Q2 really has made up for the shutdowns that were experienced in the first quarter. And so our view is that the continuation of current levels into the second half of the year would result in record market sizes across our end markets, which is challenging to understand how that's supported by the macroeconomic backdrop. So we'll see what happens there in China, but expecting that to slow down a little bit here as we enter the second half of the year. And then the ramp-up speed probably in Europe and the U.S. will differ a little bit from India, which is one of our other key end markets. India was in a challenging situation entering kind of the COVID crisis. Truck markets there were already very weak, so were construction markets and power generation markets. And that was primarily due to some challenges and people getting access to liquidity and capital, which had drove deterioration in those end markets, and that had led to a relatively challenging macroeconomic backdrop in India. As we look forward there, I know there's been announcements of stimulus measures. But for India to come back and bounce back strongly, I think, it might be a little bit more challenging given the economic situation as they entered the crisis was a bit challenging as well as the access to capital. So maybe that comes back a little bit more slowly. Europe and the U.S. will kind of -- we'll see what happens here in the broader economy in the second half of the year, which will probably drive some of the truck orders and truck production in the short and medium term.

That's helpful. And maybe just to dig in a little bit more on China and coming back to the question that came in. And the question is how much of the recent strength in China heavy-duty truck sales is underlying demand versus emissions-related pull-forward? And what are your expectations for potential payback amount and timing from emissions? I don't know if you have any clarity on what that strength is. It sounds like you kind of expect it to tail off a little bit. But if you have any views on that question, it would be helpful.

Yes, absolutely. So we are not seeing currently, I would say, any impact for the future emission regulation changes within the production -- industry production in China. So for those a little unfamiliar with that situation, China is moving its kind of diesel truck market up to the next level of emission standards called National Standard VI. And they've done this in phases, but the biggest piece really is occurring in July of next year, 2021. So not really seeing any meaningful impact to production related to that emission change today. We are very excited for that emission change to come to fruition. So it's in all of our end markets. As we see movement to more stringent emissions regulations, that provides us an opportunity to provide a solution that both improves the environment in the different regions that we participate in, but also generally speaking, increases the average selling price of our product given the increased complexity of hitting these emissions regulations. So between China that's moving to this new emission standard for most of the market at least next July and then India which is moving to a very similar standard, actually did that in April of this year, the combined total revenue impact to Cummins of those changes is about $600 million per year. So we'll start to see some of that here in 2020 in India, to the extent that there's engine and trucks made, and then we'll really start seeing the impact in China in the second half of next year. So a very good opportunity from us from a revenue perspective. And to the extent that our products perform really well in those 2 markets, which we would expect they would, given kind of our experience in these technologies around the world where we've hit these emissions regulations in Europe or the United States a decade ago, we potentially also may see some opportunities to increase market share, which, of course, would result in even more incremental benefit to the P&L. So excited for the changes, feeling really good about the product portfolio, just need to execute well. And then we should see the benefits accrue to the company over the next 18 months or so.

Great. And so in terms of -- so it sounds like there's no real emissions-related activity driving any of that strength that you're seeing in China right now. Was there any particular differentiation in the product mix that is driving that strength right now, be it heavy or medium or light? And any sense of what's really driving that? Is it mostly sort of just kind of the stimulus activity having an influence on it at the moment?

I would say, broadly speaking, all different pieces of that truck market have seen pretty significant increases. Within the individual subsegments, I would say there's probably a little bit of outside strength -- or outsized strength, sorry, in some of the more construction-related spaces or dump trucks, for example. And I think one could broadly postulate that that's likely people assuming that there'll be some increased spending on the infrastructure side, which would drive some increased demand for dumper trucks. But like I said, having said that, all of the different subsegments have seen pretty significant increases, but there's been a little bit more, I'd say, on the dump truck side of things, I think as people prepare for some potential stimulus on the infrastructure side of things.

Got it. Now clearly, we've seen oil prices pick back up over the last few weeks. And you mentioned that power gen-related markets might be a little on the slower side to come back. To what extent is the higher oil price level making any difference in what you're seeing in the business?

I would say I haven't seen any impact at this point, clearly been a pretty volatile space here over the last 90 days or so, let's say. For us, oil prices can impact several pieces of our business, right? The greatest initial from a short-term impact will be on our oil and gas business where we really participate in fracking in North America. That business, for all intents and purposes, is around 0 and has been for a little bit now. At its peak, it was just over 1% of sales, so not a huge piece of business and had already essentially dropped down to very, very low levels. I think as we look at the rest of the business, we sometimes get questions around, "Well, is a lower oil price better for Cummins or is a higher oil price better for Cummins?" Generally speaking, in our end markets, people are making investment decisions based on medium- and long-term expectations. And so to the extent that stable and relatively high oil prices are out there in the market, if that's kind of insinuating good economic growth globally, then people are actually going to be purchasing more engines to put in more equipment versus if oil prices are pretty low, maybe signaling some more challenges on the macro side. Yes, there's going to be less demand across most of our end markets based on that. So certainly, lower oil prices will help some fleets in the short run, but to the extent there are no loads to move around the country, the price of diesel fuel is a little less relevant if you have no business so...

Got it. Coming back to the truck market a little bit. Maybe just a question on medium-duty here. I know you're running really well on market share, 80-plus percent 1 year or 2 ago. Thus we started to talk about that, having an expectation of that share coming down into the 70s, but it certainly held up better than you were thinking. What do you think has been steadier on the medium-duty side and why? And where do you think that can go from here?

Yes. So it's been a really great long-term story on the medium-duty truck market in North America. If you go back 20 years in that space, our market share was below 10%. As we stand here today, it's over 80% with very good penetration across almost all of the participants in the market. So I think that as with all of our end markets, the primary key driver of our market share is going to be product. And our products in the medium-duty space are really renowned for their reliability, their good fuel economy. They are products that you can buy, put it in your truck, whether that's going to be a refuse truck, whether it's going to be a delivery van or any other number of different applications, and you can be sure that it will perform really, really well, and you won't have to really worry about any challenges in product performance. So I think that's been the key driver here of our market share gains over time. As you mentioned, I would say that, that market share has held up well given we have had 1 OEM partner that introduced a couple of years ago one of their own engines in the space, and we've maintained very strong penetration of our engines at that OEM as they launched that product, with our market share staying over 80% in the overall market. So product is performing really, really well. We have an excellent volume advantage in the market. We have very good relationships both with OEMs and fleets. We feel very comfortable that we'll be able to hold that market share and maybe even take it a little bit higher as we move forward here.

And on the Class 8 cycle, do you guys have a view as to what shape the next Class 8 cycle could look like? And then what do you think will be different about Cummins' earnings potential the next time we hit, say, that 250,000 on the Class 8 market?

Yes. I would say on the kind of the shape of the cycle, too early to tell what it will look like. So if you look at the last couple of cycles, whether it's the -- from '11 forward, peak to peak has taken about 4 years. Trough to trough has taken about 4 years. And so I think it really comes down to the area we discussed earlier, which is do we think this cycle is really just a lower trough and then we kind of keep that 4-year peak-to-peak, trough-to-trough cycle or does this get extended out. And I think that remains unclear. In terms of Cummins and profitability and opportunities to improve our position over time from a P&L perspective, we feel really good about that. So there's a set of different things that I think we can do to improve our performance cycle to cycle, so always working on kind of continuous improvement activities, whether that's product coverage or warranty, taking material costs out of our products to improve the margin profile, whether it's the continuation of improving our position and growing revenue in transmissions, which has been very successful over the last couple of years, and then a continually increasing population of engines, both in the heavy-duty and especially the medium-duty truck market, which is really driving good growth in our Parts business over time. And of course, what happens is we see markets recover a little bit. Some of these older trucks that are currently parked just due to lack of freight activity, as people put those back on to the road, that will generally drive a nice little bump on the Parts revenue side, which we'll see usually just before orders start coming back as people make the decision to trade up maybe from that older truck that has a little bit of an increase in running costs to a new fuel-efficient truck. So that is generally what we see from a cycle perspective, and both of those dynamics should help our P&L over time.

Great. Maybe to shift gears, we have a few minutes left here, curious about what partnerships you think have the biggest potential upside in the next 2 to 3 years. If you had to pick the top few, what would they be?

Yes. So unfortunately, I can't pick the top ones. All of our customer is critically important and good relationships with all of them. I think I would just frame this as we have commercial relationships with 17 of the top 20 commercial vehicle OEMs globally, and we're consistently having conversations with all of them about how we can help support their product plans in the future and how we can help support their customers and improve their total cost of ownership and help them get their job done more efficiently. So I think over the last 6 months, we've had some really exciting announcements about availability of our engines in North America both in heavy-duty with Freightliner and our 12-liter engine in regional haul applications, with Mack in medium-duty in North America as they enter that market and the new after-treatment customer in India with Ashok Leyland, which will drive over $100 million in revenue. So I think those are the fruits of a lot of good work, a lot of good conversations, and I think those relationships continue to deepen. And then, clearly, they see the value of the Cummins proposition when they've made those decisions. And I would expect, as we move forward, that we would have more opportunities with our OEMs to increase business with them in the same way we have with a couple of those customers that I just referenced in the last 6 months.

And maybe just to wrap up here. Would be really interesting to hear a little bit more about Hydrogenics and what you're doing there. Can you talk a little bit about where that falls in the prioritization of the alternative power business? What's the playbook there? And then to what extent are you seeing competition coming in from China on the new power side of the business?

Yes. Very excited about the opportunities in the fuel cell side of the business. So we purchased Hydrogenics last year, which kind of increased our participation both on the fuel cell side and in hydrogen production, in electrolyzers, which I think is an important part of the story. So I think probably too early to talk about market shares and competition. I think we're still kind of early in the game and a lot of research and development work going on. But in that vein, we have over 2,000 fuel cell installations out there in the market, in buses, trucks. We have trains running -- you can hop on a train in Europe today with Cummins fuel cells, boats and a couple of other different applications of stationary power generation. So we have fuel cells in applications all around the world, learning every single day. And we feel very well positioned given the experience we're building in a myriad of different end markets that as specific markets become ready for this technology, we'll be very, very well placed to compete and win in those markets.

Well, a lot to dig more into, but we are out of time. I want to really thank you very much for your time and insights, James. And we look forward to talking to you and everyone soon.

Great. Really appreciate it, Steve. Thanks so much.

Thank you.