Cummins Inc. (CMI) Earnings Call Transcript & Summary

Good morning, everyone. I'm Courtney Yakavonis, the U.S. machinery analyst at Morgan Stanley. Next up, we have Cummins with us. But before we begin, please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. The webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see Morgan Stanley's research disclosure website at www.morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales representative. So as many of you know, Cummins is a manufacturer of engines across various different end markets in both on-highway and off-highway as well as aftermarket components and distribution. I'm very pleased to have with us this morning, James Hopkins and Matt Ruch from the Investor Relations team. James and Matt, thank you so much for joining us virtually today. So James, I believe you have some brief opening remarks, and then we will open it up to Q&A. [Operator Instructions] So James, go ahead.

Yes. Good morning, everybody, and thanks, Courtney, for the invite. Really happy to be here. This is our second year in attendance. This year, virtually, a little bit different than last year, but happy to be able to participate again this year. So just some real brief comments to start with. I think as many people are more than aware, a challenging first half of the year in many of our end markets, whether that's due to COVID or some cyclical declines in some of our end markets, particularly North America truck, that were starting to occur before COVID hit. Given the decline in revenues that we experienced in the first half of the year, we feel very good about the profit that we're able to bring to the bottom line. We've done lots of different things to help support that. We announced a restructuring plan in late last year in preparation for some kind of cyclical downturns in North America. We also implemented some temporary cost reduction actions as the impact of COVID became clear. As we look forward, we are seeing improvement in most of our end markets, particularly North America truck. And then looking further down the line, we feel very confident about our competitive position, opportunities, market share gains, growth related to emissions content and, of course, some of the new technologies we're investing in and how we can leverage those, whether it's battery electric, fuel cell or electrolyzer technology.

Great. So maybe if we can just start off talking about production trends. I think ACT was out this morning with the latest build rates, but you've been talking about how you've seen the Class 8 OEMs successfully increased build rates back to pre-COVID levels. So can you just give us an update on -- are you -- what are you seeing in terms of build rates on your off-highway markets? And on the on-highway side, have you seen any improvement? Or have they been pretty stable at those Feb, March levels?

Yes, absolutely. As you mentioned, on the on-highway space, specific to North America, the industry has been producing for a couple of months now right around 20,000 units, which, in essence, is very similar to the levels that were being produced in February and March, so pre-COVID. At the same time, industry orders have also kind of hovered around that 20,000 unit level, supporting that level of production. Outside of the on-highway market, the off-highway market do have some slightly different dynamics. I'll kind of highlight a couple of them. So on the construction side, I would say, recovery has been more slow, which we kind of talked about that a little bit on our second quarter earnings call. And that's partly due to the fact that we had a significant amount of equipment purchased over the last couple of years. And so those markets were already starting to weaken in the second half of 2019, continue to be weak pre-COVID in the first quarter. And so we still have some kind of more cyclical things to work through, I think, before we see meaningful growth on the construction side of things, both in the United States and in Europe. We also participate in mining markets. And so for us, that's an important piece of the portfolio within our Power Systems segment. We had seen weakness in mining market -- certain portions of mining markets, again before COVID, primarily coal-related end markets, which represent about 50% of our exposure in that space. So that kind of weakened into the first quarter of this year, remained quite weak into the second quarter, and we still do not see much sign of improvement on the coal-related piece of the mining portfolio. On the other hand, the other 50% more related to copper, iron ore, gold extraction, demand in that space has remained relatively stable over the last year. Haven't seen many changes there. Certainly haven't seen meaningful changes in the last 3 or 4 months regardless of the change in commodity prices in that space going up quite significantly. So not unusual for those off-highway markets. And then others we participate in, such as power generation, to take a little bit longer to recover versus the truck markets, which tend to be a little bit earlier cycle. But that's kind of how we see those end markets today. Clearly, still a lot of uncertainty in the market, given the situation with COVID. But that's kind of how we see things today given the current situation.

And on the North American truck cycle, I think you guys had, at your Analyst Day back in November, suggested that we would start to see an uptick at the beginning of 2021. ACT has begun to raise their build estimates now. Do you have a strong view on ACT's forecast? And based on what you're seeing, how optimistic are you for the recovery? I think Daimler was here yesterday saying that they think they could see next year kind of back to the 10-year average.

Yes. I think it's too early for us to kind of provide any kind of specific guidance for next year on that. But as in prior cycles, there are certain things that we'll look at to kind of determine how we anticipate demand in future quarters into next year. So we've seen an improvement in freight rates. That is supportive of fleets purchasing more trucks. We continue to see new trucks with better fuel economy, improved safety systems, drivability with automated manual transmissions that do provide some incentive for people to replace their older trucks with new trucks. Of course, really important for many people that there's an ability to sell their old truck as they trade in. The used truck market has improved a little bit in terms of quantity of trucks being able to get sold and at least a stabilization in the prices that people are able to get for the used truck. But the prices are still meaningfully low where they were a year or 2 years ago. So the metrics seem to be moving in the right direction. Still a lot of uncertainty out there. But certainly, metrics moving in the right direction that could suggest an improvement in demand over the medium term.

Got you. Maybe moving over to China. Clearly, you've been recovering much faster than the rest of the world. You called out heavy-duty and medium-duty truck demand up over 50% and 2Q excavator sales up also over 60%. So how are you thinking about this recent strength and how sustainable it is? And any thoughts on government stimulus over there?

Yes, absolutely. So Q2 was an incredible quarter for our business in China. We had record revenues, record profitability. Almost every market we participate in was at record levels. In the truck market specifically, the annualized demand for trucks in Q2 was 2.3 million units. I think the highest ever full year demand for trucks in China is 1.4 million. So you can see just how incredibly high demand was. Part of the strength in the truck market and also the construction market, which is our other primary market in China, was certainly driven by catch-up from industry shutdowns in the first quarter. But we also did see some stimulus-like measures that we think have augmented the demand in the second quarter and also running into the third quarter. One of the items that we've kind of highlighted in relation to that is on the truck side of things, that there's been a push to scrap some of the older national standard 3 emission level trucks out in the field. So those trucks now are several years old. And in essence, in some regions, you've seen regulation put into place, which means that folks can't drive those trucks on a highway or into the city, in essence, creating demand for new trucks in the marketplace. Our estimate is that some of that scrapping of older trucks this year has resulted in incremental demand of somewhere in the range of 250,000 to 300,000 units, a pretty sizable number, and that certainly kind of buoyed the market. Unclear how that will continue into 2021, not something that I think that I have a good enough crystal ball to kind of figure out. What I will say though, as we go forward into China next year, we do have some nonmarket-based opportunities in terms of growth. So the rest of -- the portion of the country that isn't at new emission standards and at 6 level will move to those levels next July. That will provide us an opportunity to increase sales of our after-treatment systems to help folks meet those regulations. The annualized impact of that is around $300 million a year, and we'll continue to increase selling our transmissions through our Eaton Cummins joint venture. So we're planning to sell about 1,000 of those transmissions this year in China. I expect that to increase meaningfully going into next year, which will also provide a revenue bump not related to market size. We're also hopeful that as we introduce our NS VI product into the market, we have over 10 years' experience with similar levels of emissions, whether it's in the United States or Europe. And so we feel our product portfolio and our offering to customers in China will be pretty compelling. And so hopefully, we will see some market share increases as people take on board these new powertrain portfolios and see really good performance on them.

That's helpful. Maybe moving on to India, much different story over there. You've mentioned that nearly all of the company's end markets there are extremely challenged. Have you seen any signs of stabilization in this market? And what do you think it's really going to take for this region to recover relative to other regions? And I believe there's also some emissions regulations opportunities over there, but has that time line shifted at all?

Yes. So really challenging conditions in India, which frankly started before COVID. Starting in the middle of last year, we started to see the negative impacts of low credit availability in the truck market in India, where the majority of customers are owner-operators and essentially look to finance their truck purchase through these shadow banking organizations. And the ability of folks to do that really dried up. So we saw a negative impact of trucking kind of starting last year in Q3. And then we started to see that trickle-down effect into Q4 in construction markets as construction of new buildings kind of started to slow down as people weren't able to get financing for construction. And then we saw it flow through to power generation in the first quarter of this year. As you can imagine, less new buildings being put up and so less backup gen sets. So the situation in India was very challenging before we even got the additional challenge of COVID in the second quarter. So still rough today. The credit challenges in the industries we participate in or facing remain. It's still very challenging to get credit and to finance a new truck or a piece of construction equipment or building a new building, and that is impacting our end markets negatively. I think as we look forward, that availability of credit will be critical to helping support the market and getting a little bit of growth out of India. We're confident that over time, that will happen. And when it does, we'll perform exceptionally well. We have very high market share positions across industries in India. We've been doing business in India since the 1960s. And on top of being able to leverage that strong market share, we'll also leverage the new emissions regulations that you mentioned. So the industry there, the truck industry, did move to these new emissions in April of this year. And so when the truck market returns, the annualized impact of those regulations on our revenue is about $300 million, similar to the number I referenced in China. So very challenging right now. But as we look forward, when the markets do recover, I think we'll perform quite handsomely in India over time.

In your opening comments, you mentioned some of the cost actions that you started in November of last year, and then you obviously took the incremental $75 million of temporary cost savings. So can you just comment on us on how confident you are that you can achieve that 25% decremental framework in the second half of this year? And anything we should be thinking about as we think about incremental margins in 2021 and how those will be impacted by some of these costs coming back in?

Yes. So for several years now, we've provided this framework on margins where we see incremental decrementals in this 20% to 25% range. To the extent that we fall out of that range, either with our actual results or with any kind of guidance, then you should expect us to kind of explain why that may be. And then the first half of the year, we've kind of been in that range. We don't have official guidance for the second half of the year, given the uncertainty in our markets. And so how we've been really framing the second half of the year is discussing how it may change from the second quarter results that we had and really viewing it sequentially. So the items we've really highlighted from a sequential perspective are kind of as follows: that we had very, very strong warranty performance in the first half of the year. In Q2, our warranty as a percent of sales was 1.9%. An average performance for us on warranty is more like 2.5%. And so all else being equal, we would expect a little bit of a headwind from Q2 levels on warranty from 1.9% to, say, 2.5%. Other item you mentioned was joint venture income. So China was incredibly strong in the second quarter, and we participate in China in many ways through joint ventures, so very high joint venture income in the quarter. So to the extent that China is cooling into the third quarter, we'll see a little bit of a hit to the joint venture income in China. On top of that, we talked about research and development. So in the second quarter, a lot of our employees, for an extended period of time, were not able to get into our technical centers. And so our spending on research and development activities was below where we would have liked it to be. That is not money that we were looking to save. That is an investment that we're looking to make to improve product quality, develop new products, improve fuel economy, things of that nature. So we are looking to catch up some of that spend. And so you'll see an increase in research and development from Q2 to Q3. And so those are kind of the general headwinds sequentially that we expect. And then all of that we'll be looking to see to the extent we can offset it with volume. So we mentioned in our Q2 earnings call that we expect Q2 to be the bottom of revenues for the year. We expect improvements across our markets. We've historically done quite nicely of giving the volume leverage when we see increases in net sales. And so that will be what we look to try and offset those cost headwinds into the third quarter. As we look to the fourth quarter, the other thing to keep in mind is that we will see the temporary salary reductions that began in April and run through the third quarter. Those will end. And so from Q3 to Q4, we'll have a headwind of about $90 million from resetting those salaries back to their normal levels. In terms of next year, full year 2020 versus 2021, the items, I think, to keep most in mind are going to be those temporary salary reductions. So those all have totaled about $165 million this year in the second and the third quarter. So that will be a year-over-year headwind from a cost perspective. Given the challenging markets we're facing this year, our variable pay will be below a base payout this year. And so from 2020 to 2021, you're talking in the range of $200 million of likely incremental cost on the variable pay. Those are really kind of the 2 big numbers. Then, of course, we'll see how volumes come out for next year. We'll look to leverage that as much as possible to improve our margin cycle over cycle, and we'll continue to make improvements in our Distribution business when we're -- while we're kind of in the middle of a transformation process in Distribution here in North America, which will bring sustained improved performance to that business unit from an EBITDA percent perspective.

Great. That's helpful. Maybe moving on to alternative powertrains. You've obviously been making a lot of investments in your New Power division in both battery electric and hydrogen. But can you just talk maybe at a high level, your views around how electric and hydrogen will be adopted, how early you think it's possible to see in certain geographies and truck categories? And then you've also kind of mentioned that you could be a potential beneficiary during the transition period as OEMs might rethink the amount that they want to invest in diesel. Have you seen any evidence of OEMs kind of giving some of their R&D to Cummins versus making the investments themselves?