Cummins Inc. (CMI) Earnings Call Transcript & Summary

Good morning, and welcome to the 8th Annual Crédit Suisse Industrials Conference. My name is Jamie Cook, and I'm the machinery and engineering and construction analyst at Crédit Suisse. In terms of the format for today's fireside chat, I will moderate the Q&A with management. If you do have a question, please e-mail me at [email protected], and I will get that question asked for you. Without further ado, I'm very pleased to introduce the management team of Cummins. With us today, we have Mark Smith, the Vice President and Chief Financial Officer as well as James Hopkins, Executive Director of Investor Relations. So thank you both very much for being here, for being supportive of the conference. Cummins obviously has a great story to tell with penetration in diesel engines, secular growth in some of the alternative powertrains, good cash flow and good peak-to-peak and trough-to-trough earnings improvement. With that, I'm going to hand the baton over to Mark. I think he'll start off with just a brief overview of what he's seeing in the markets, and then we'll open it up to Q&A. So thank you, both, Mark and James, for being with us this morning.

Great. Thanks, Jamie, and good morning, everyone. Happy to join. Much more fun in person. But anyway, I look forward to this event. So just a quick run around the world. In aggregate, we’re generally seeing demand continue to improve. You can see from publicly available data that truck orders in North America have exceeded expectations. I think today we'll see -- we expect to see November truck orders, but our customer sentiment is pretty strong. In China, whilst we're seeing that natural seasonal easing from the first half of the year to the second half of the year, demand remains -- also remains strong and still significantly up year-over-year for the industry in October and November. So those trends continue from the third quarter. And then we're starting to see some raise of late, I would say, in India. India is probably the region where we've had the most challenges from COVID, and we are seeing improvement. We saw revenue declines in Q2 of 60% to 70% in aggregate in India. And slowly, but surely, we're starting to see improvement there. So it's very much truck first recovery here so far, Jamie. We realize we've only got 1 or 2 strong data points in North America. So we're just -- as investors are, we're always looking for signs of improving demand, but North America for now remains pretty strong, truck side, pickup truck side, parts, after a tough summer, starting to see some improvement on the Parts side of the business. Power gen, yes, it's a mixed bag globally. We've continued to see throughout this year fairly strong demand for data centers. And then it's a mixed bag for the rest of the commercial and consumer markets. So it's mostly been going sideways. Construction is very strong in China. Record levels of demand for excavators this -- in 2020. That remains strong going into the fourth quarter. In the U.S., it feels like we're bottoming out after a strong cycle through 2019. I haven't seen any great moves to the upside, but it doesn't appear to be getting any worse. Mining, we can take some questions on that. But generally, it's been a little bit disappointing cycle in mining so far, and that's been going more sideways for now. So that's most of our markets kind of current trends. As you say, cash flow for the company has rebounded strongly after a tough Q2 and that we expect that to continue. And we've said, going into next year, after the caution of this year, the base case is then we start returning more capital back to shareholders in 2021.

Okay. I guess -- and just to add on that, is your commentary on the construction markets, I guess, the U.S. construction market is a little more positive relative to where we were before? And I don't think you touched on oil and gas. I'm assuming that's horrible. And then last, just China, it's been better. I think we got numbers out again this morning, which have been much better. I'm just wondering how that plays into your 2021 because we're always doom and gloom on China, but…

Yes. It's definitely boom not gloom in China right now. So that's -- I'm not really renowned for the boom projections. That's true. But yes, it's surpassed all expectations. And a big part of that, but not all of it, has really been the government's push on taking older NS III and prior older vehicles off the road. And we think that's boosted the market size to the tune of 10% to 15% this year beyond what we would normally expect. I would say, generally, for the company, we've had more challenges in the nearer term on the ramping up side. So we have seen some tightness in the supply chain, both COVID infection rates rising in our supply chain. And then yes, some inflexibility in the supply chain. So the purpose of that is not to say like, well, with me, just to let you know, whereas in Q2, we worried about where demand was going from, that's really -- that scenario has changed in the near term for Q3 and Q4, and it's really been a story of demonstrating more of this kind of operational flexibility ramping up. But I would say most of the momentum and continued strong news for Cummins is really on the truck side. So construction, I'm optimistic about things going forward, but from a materiality…

It's not going to move it.

Yes.

Okay. And then another question, the opportunity for market outgrowth. When we think about 2021, like how we should think about Cummins' market share? I'm assuming there's opportunities on the X12. How you're thinking about automated transmissions? And then, I guess, broadly, the market's been waiting or hopeful for some opportunity of increased market share in diesel both in sort of Europe and South America and whether that's something we could potentially be talking about in 2021.

Okay. Great. Yes. So our -- most of our outgrowth in 2021 is reasonably well known. Certainly, you're familiar with most of the big drivers. So we've got the emissions regulations in China and India. India went to BS VI this year, but it's been the actual demand levels being very suppressed. So there's clearly a leg up in India, not just on Cummins engines, but we've won some additional new customers. And then China, really the big push to NS VI starts around the middle of the year next year. And the combination of those 2 takes us up in the range of $600 million over the next 18 months or so as those markets recover and we get fuller penetration. Transmissions business. So we knew when we were partnering with Eaton, they had great strength with their technology in North America compared with the Cummins engine, heavy-duty engines in North America, and we both saw good opportunities to leverage customer relationships in emerging markets. And I think we'll start to see some traction there in 2021 with automated manual transmission. So that's early, but we are getting some traction with customers there. So that points to a longer-term growth trajectory. And then yes, market share, in the short run, it's mostly, as we were, I think, generally, the OEMs and our end customers rely on Cummins to flex it well. We tend -- our demand tends to get suppressed the early stages of the downturn as OEMs primarily managing their own fixed costs early, but that -- so we get these distortions. And then on the way up, often times, we can flex up as well, if not a little bit better than the rest of the industry because we've got that flex capacity. And so we can continue to ramp up fairly well. And I think all points to solid market share. And then, yes, you're right, the 12-liter comes -- start to pick up more volume this year. But I would say in North America, the changes in market share should be fairly incremental, not dramatically different in 2021. And then to your bigger-picture question, yes, we continue to try and persuade some of our customers that our scale advantage really can help them as they transition to higher investment levels in new technologies. Nothing to announce today, but those conversations and that pursuit continues here. And yes, we hope we can pick up more share both for the Engines and Components business.

Just to build on that, is the opportunity still Europe and South America? And then the question is, given the scenario that you think could play out, what level of investment do you think will be required by Cummins, either manufacturing or R&D or whatever? Because I'm just trying to think, should we think of this as there's going to be investment by Cummins? Or is this sort of an incremental market share with little investment, which then really could have implications for the longer-term margin potential of the companies you're just pushing more through your system?

Yes. Good questions. A couple of dynamics. So number one, we're going through refreshing some of our diesel engine platforms now as we get ready for 2024-2027. So generally, our engineering as a percent of sales has been trending up, and we've been really pushing on efficiencies in the SG&A side to try and compensate for that. And we are making some modest capital investments in our -- particularly in our North American facilities, kind of retooling for some of the next-generation engines. And so our hope, and as a CFO, my hope is that most of that investment is already in our core plans. And if we can pick up more business, then that's simply going to help the return on those investments. And in any event, like a capital side, we're going to stay within that typical range we talk about, 3% to 4% of sales. We pushed it down in 2020 because of the uncertainty. We'll see a step-up in CapEx next year, but it won't be extraordinary. But I think we can manage it within the normal parameters. And I think where this gets to it, our view is that some OEMs have invested in engines for strategic reasons, not purely financial ones. And as we look at getting closer to the internal combustion engine peak and the regulations continue and require more investment, that economic case gets even more challenging. And our price is likely better than some cost. And therefore, we think there's a win-win in that scenario. And again, we're looking to do that wherever we can in the world. We're not narrowing that down in one particular region. So it's, hopefully, at some point, we've got something more quantifiable to talk about in that regard. I would say as a minimum, the conversation with customers about them making more of their own combustion engines, that's much less of a risk today as we see it than we have done through most of our history, given the change in demands.

Okay. And I'm going to shift all over the place because we need to give James some props for his Hydrogen Day. So James, congratulations on what I think everybody thought was a fairly successful day. But Mark, a couple of questions. Obviously, the revenue contribution from hydrogen is not that significant with your 2025 goal, but I think what would be interesting from my perspective is how we think about the partnership opportunity. Maybe -- you made the announcement with Sinopec, which I think was a positive partnership. But how do we think about partnership announcements? And where are the holes that come in sort of needs to fill first? And then as the CFO of the company and investing in new power systems, I'm just trying to understand how long this can be a loss-making division? You know what I mean? What's a reasonable time frame for this to start to generate money or how to think about the longer-term profitability of this business?

Yes. So I'll start at the end, and then we'll work backwards from there. I think the key to get into profitability is twofold. One, we need to move to more adoption and less new programs on the battery electric side because that's all bundled together, as you know, with the hydrogen side. So we've still been in fairly high R&D mode on the battery electric side. So we need to convert more of that to revenue going forward. And the second piece is making sure that, as you say, it's not earthshattering. It's more the electrolyzer business is more of a sign of enabling broader adoption of hydrogen. Yes, we can capitalize a little bit on that in the near term and build our name, quite frankly, Jamie, in industries where we -- and with different partners, potential partners, where we don't necessarily participate today. Yes, we have rail business. So it's -- that would be a choice, but some of the opportunities to clean up the hydrogen production that's out there or make hydrogen more available is naturally going to take us into discussions with companies where we may have sold them something in the past, but we maybe haven't been a significant part of their overall industry. So I think you could definitely see some new partnerships evolving. And we'll see. Again, part of the challenge is ramping up this whole industry right now. So there's excitement about the demand for electrolyzers, and it's -- we've got capabilities. We've got scale, but that's scale and that presence globally is going to have to be adapted for these different applications. And maybe there's some important partnerships if that really starts to take a bigger hold that could help outside of some -- maybe some of our core truck names, as you point to. And again, we're well positioned in China. We're trying to grow our presence in Europe with some of the new programs. And then in terms of -- the good news is our core business or the combustion engine business continues to generate improving performance, both margins, EPS, cash flow. So I foresee, for the medium term, we're comfortably generating more cash, operating cash flow than both the combustion engine business and the new power business needs, and that's where we've already kind of signaled returning more cash next year to shareholders as kind of the base case now we're moving beyond peak uncertainty through COVID.

So I guess you've hinted to cash several times throughout whenever I've asked you a question. And I think the cash flow conversion for Cummins has probably been better than people would have expected. So I'm trying to think through, just structurally, is there a better way to think about your cash flow conversion going forward and priority -- I mean it doesn't sound like there's much any more on the M&A front relative to how we used to talk about things. So given the run in your stock, too, how do you think about being -- I mean, is share buyback still the priority versus dividend? And I'm just trying to think if you think people still under-appreciate the earnings power of Cummins, given you're still talking about repurchase with your stock at these levels.

And there's a couple of reasons why I mentioned the cash. One, of course, it's a great thing to have. And then number two, I think it's quite sustainable, and we're not requiring shareholder equity to keep our business going while we're waiting. We've got this kind of combination of a very strong foundation and a lot of infrastructure. And we're an already established partner for a lot of the players in our industries that make us a natural choice if we can demonstrate on the new technology side. And I think that, at least my personal view, at some point, that cash need is going to become more relevant, right? There's a lot of enthusiasm, excitement for things that, quite frankly, are going to take more than a decade to be really material to some parts of the world. And so we've already got a distribution system, a global footprint. Yes, we're going to have to do some adaptation, but it's all within the envelope of a very strong cash business. And at least we're trying to make to the case -- investors, we can pick up more diesel even if the markets are getting closer to peak, both for the Engine business and Components. We can keep growing the cash generation, keep return and you've got that optionality on the New Power business. So that's why I mentioned it. I think we've, gradually, over time, improved the cash conversion of the business from around 10% of sales to 13% of sales. There are really 2 key factors in that. It's margin improvement. And I think the piece that's underappreciated and maybe we don't do a perfect job at, the Parts business behind the scenes just keeps ticking away and growing. And the more we picked up share, the more population we've got out in the field, the longer that tail is. And I think some of the early fear around -- yes, first of all, battery electric was there's going to be an impact on the aftermarket. And we see good visibility at the longer-term growth, which will help margins and cash, I think, going forward. So that's why I mentioned all those things. On the M&A front, I'd just maybe add a little bit of color. True, prior to maybe 2015, and still, we've been growing at around 7% to 8% primarily organic. And then when you compound that with margin expansion and then more returns to shareholders, this has been a good combination for the value driver of the company. We had a view that, that growth rate could start to slow as emissions regulations start to harmonize around the world and the hardware adds from the Components business, whilst there's still some legs on that to grow, that rate of growth would start to moderate. I think -- and that's -- that was really the genesis of the discussion around looking at more inorganic opportunities. I think what's happened in the meantime is the intensity of discussions or opportunities or windows opening up on winning more diesel have increased beyond our original expectations. So why -- I'd look to announce something just as much as investors look to hear it, I can just say that windows opened up, at least conceptually far more than we thought when we were thinking about the longer-term growth rate of the company. But still, we're open. We're still looking at, are there any opportunities to strengthen the portfolio of the company long term. But the honest answer is, one of the biggest challenges, so much low-cost financing around than anytime you look at any deal, it makes it hard. It's a very crowded space and we have an obligation to do the right thing in terms of long-term returns for the shareholders. So we think this combination of what we've got will produce -- has every potential to produce good outcomes for owners, but we haven't totally stopped looking at ways to improve the portfolio. But you're right, the base case is more cash back.

Okay. And then just also aftermarket, you sort of mentioned that. And I feel like aftermarket is something that industrial companies are talking about more and more. But what I -- as I think about the biggest buckets for aftermarket for Cummins, is it just -- you bought your distributors. Is it your market share increase that you've had on the medium-duty side over the past 10 years and that starts to kick in? Is it China? I'm just trying to think about what that opportunity is, your addressable market and sort of where you're underpenetrated to frame that story better.

Yes. I think one of the pieces -- the tighter emissions regulations created an opportunity for new hardware sales at the start in our Components business. But the way the regulations were implemented, they required fairly long, let's say, warranty or guaranteed performance levels of some of those components. So therefore, it takes longer to get into commercial parts sales, in some cases beyond those warranty periods. So I think that tail has been building up and just continues to grow. So there's no doubt the regulations and the share in North America, first of all, continue to provide a tailwind. And our share -- yes, you're right, on medium-duty, it's been growing, but the revenue per part has been going up as well because of the rising sophistication. And then I think still there's opportunity in India and China. And then the Power Systems business, I know it hasn't had the same secular growth themes, but that is also a very good Parts business buried in that. And we always have those Engine parts. The addition of the Distribution both adds that extra slice of parts and service to the retail customer or the end user. And then we think -- of course, that, hopefully, that good quality service then reinforces back to the market share. So we think -- we're hoping for that virtuous circle. It's all of those things. But so far, it's been more of North America for reasons I've described. And I think, hopefully, we can keep growing in China and India, in particular.

Okay. And then we did get a question e-mailed. And of course, people -- they appreciate your thoughts on the top line for 2021 or which markets can grow. But there's a lot of concern, I think, about incremental margins for the group. As you think about some of the discretionary costs that are coming back into that incremental margins in an upturn aren't what we hope they would be, just like I think decremental margins probably surprised on the upside this year. So outside of the cost that you sort of laid back that come back in, which you can refresh everyone, what are the other variables we should consider? Are there mix factors? Is it more a function of volume? Just the opportunity for Cummins to put up above the incremental margins coming out of the cycle or coming out of a downturn, assuming I'm right, on the markets?

So I will -- I'll quickly but try not to bore people with the refresh on those known and quantifiable headwinds, just so I don't leave anybody with a misunderstanding. So we implemented, yes, on average, about 20% salary reductions for a period of time during this year when we – during uncertainty. That's all fully restored and will be visible in our Q4 results. But on a full year basis, going into next year, that's $165 million headwind. Our bonus plans have flexed down with lower earnings, but there are still -- we'll still pay out based on current projections at a decent level for this year, but that could be another $70 million to $80 million headwind going into next year, assuming we hit our targets for next year. I think beyond that, the real -- so those were unplanned. They definitely, particularly the salary cuts helped to protect profitability and cash flow for a while. Warranty costs have been running lower than normal. And I'm not trying to -- I'm neither trying to cry wolf or anticipate big issues, I'm just saying we started 2020 with our internal plan thinking about 2.5% of sales in that order for warranty, and it's been running at about 1.8%, 1.9% of sales through the first 9 months of the year. And the base warranty and our accrual, that's all fairly consistent. What's been a surprise really is such a low level of field campaigns, partly because customers were not necessarily bringing in vehicles for repairs at the normal -- it's been a fairly unprecedented low level of field campaigns. And I'm not talking about these big charges that we've run into in the past, Jamie, just more of what I call routine updates to products and changes. Those have been very low. And so that's knocked about 60 basis points off of our product coverage. Could that continue at a lower rate? We would not expect it to. In fact, we'd expect some tick-up in the fourth quarter. I'm not trying to overdo it, I'm just trying to be really clear on the numbers. Then to me, there's a couple of factors. What we're seeing today is North America demand is improving. That's our biggest market. It's very profitable market for us. And then China, if we just think about the EBITDA percent or EBIT percent or whatever metric you prefer to look at, JV earnings boost those margins on a percent basis, and how will China play out next year. Right now, as you said, demand has remained strong. We've got emissions regulations coming in the middle of the year. What -- we know we'll get incremental business from that, but what will be the overall market shift. So I think that's going to have an impact on those. Undoubtedly, we'll -- beyond the North American volume, it's really what happens in China. That's what we've got to look at. The rest of it is just -- those are known kind of quantifiable headwinds going into next year on the people cost side.

Okay. And then I guess, just on -- I think we only have 2 minutes left, but the distribution margins, I think, have been an area that have surprised on the upside for Cummins, and it was I think something that you brought up at the analyst meeting before at the Hydrogen Day. So what's left to be cut there? And I'm just trying to figure out how much of that an opportunity is, what inning of the ball game we are on that front.

Yes. I think we might be -- not as familiar with your ball games, but I think we're maybe like sixth inning, maybe, definitely not in the eighth or the ninth. I still think we've got momentum in North America, where there's been a lot of focus. And maybe we didn't get all of the momentum we're expecting early on, but we've really got quite a lot of traction there. But I think there's opportunities in other parts of the world where, yes, performance hasn't been quite as we've expected. So we're making some adjustments in 1 or 2 areas of the world. That won't be as of the magnitude of North America, but I think we can take some of the lessons we've had here and the improvements we've made. So I think you should be -- we're looking for more margin improvement here yet, clearly in Distribution going forward. No question about that.

Okay. Sorry, Mark. And I got one other quick question from the field. They said, has your view changed on when you see diesel engines surpass -- sorry, alternative powertrains surpassing ICE or diesel engines? Like what's your view on when that happens?

Yes. I mean there are a range of scenarios, but it feels to us like the next 10 years are certainly going to be very healthy years for combustion engines. And again, if we can strengthen our relative story by picking up more, then that becomes -- we become even more the scale player with influence over the broader supply chain as well. So yes, I think for the next 10 years, we feel like there's a clear strong range that we could cycle aside, keep growing out combustion engine, and we don't see a dramatic change. And again, it very much varies market by market and region by region. We're not trying to be the spoilers. We're just trying to fairly describe how we see the markets play out for hydrogen, which we think fuel cell technology longer run as better application in some of the higher-energy density applications than battery electric. We've said that all along. Now I think we're not the only people saying that. So investors are going to have to be patient on that side. But that means, still, I think we've got high volumes of combustion engines for quite a long time to come. And that's -- if we're generating $2 billion to $3 billion of operating cash flow, but that's a lot of cash, right? That's a lot of cash to be able to generate over the next decade. And again, I don't -- it's not going to be a cliff event either thereafter. And hopefully then, the Parts business keeps growing throughout that period, that makes that tail -- means that we can keep growing for longer than that in the combustion side.

Okay. Well, I think we're out of time. Both Mark and James, I appreciate your support and coming to the conference. Always good to see you guys. Have a healthy and safe holiday. Thank you so much.

Thank you. Appreciate it, everyone.

Thanks.