Cummins Inc. (CMI) Earnings Call Transcript & Summary

Good morning, everyone, and welcome back to the Wolfe Conference, Transport Conference. It's Thursday, May 27, 10:15 Eastern time. We're very pleased to have Mahesh Narang, President of Cummins Component segment; as well as Jack Kienzler, the Executive Director of Investor Relations. So if -- with our fireside chat, we love to get your perspective what you're seeing across the global truck segments. which regions are performing better, which are struggling right now.

Thanks, Rob, and thank you for having us. Both Jack and I are really happy to be here. So this is Mahesh and I'll start with just a brief overview of what we are seeing in our markets. And broadly, globally, we are just seeing extremely high demand region by region, but North America is significantly up, and we've upped the guidance. And a lot of our end markets are up. Heavy-duty is up around 45%. Medium-duty market in North America is up about 35%. And even the pickup demand is higher this year by about 15%. China had an incredible first half primarily because of the NS V prebuy. So that demand has really propelled our performance in Q1. And demand in Q2 is also strong. We do expect a slight tail-off in the second half of the year as the prebuy inventory gets depleted in the market. India, which came off a very low base, is also up almost 100% and compared to 2020. But again, it's off a very low base. We are cautiously optimistic about India with the COVID shutdowns we are seeing off late, but the demand is robust. And we are hoping as pandemic comes in control, we continue to see the momentum there. And we're also seeing similar things in our -- in Europe. We are seeing similar things in our power generation market with data for data centers. We're seeing similar demand in construction and mining. So overall, all our markets seem to be doing well, and we feel fortunate to be in this position. The thing that is slowing us down from selling even more is the supply constraints and mostly around semiconductor chips. Cummins is a global company, so we have been able to mobilize things across the world and ship parts from one part of the world to another and generally kept up with what our customers can build. But we expect those constraints to continue through the year. We do -- but we do see some improvements in our supply chain and hope that the premium freight that we paid in Q1 slowly tapers off over the rest of the year. And the last thing I would say is we see the demand holding. So if -- it's not going away, so we feel pretty confident that if we cannot furnish the demand through our OEMs this year, it flows into next year. And so we are glad that we are seeing the market shape up for a good couple of years.

That's certainly what we're hearing from our -- the trucking and LTL companies that were presenting yesterday and on Tuesday at our conference. With regard to the supply chain constraints, on the first quarter, you guys noted roughly $100 million in terms of cost headwinds related to expedited freight. We saw that kind of moderating to around $60 million in the second quarter. How is this kind of playing out on the cost side relative to your initial expectations? And just for our reference, can you give us a sense how much of this is tied to using more expedited freight, i.e., airfreight, ocean or expedited truckload instead of intermodal or normal truckload? And how much is just higher transportation costs?

Yes, sure. So I can take that one, Rob. So you're right. I mean we had guided at the beginning of this year to elevated costs. We saw about $105 million in Q1. The majority of that is related to premium freight, airfreight plane, parts and components from region to region. The balance of that cost is -- increased over time as we've tried to [indiscernible] when you're getting product in the door and when you can build engines out of those facilities and, of course, the logistical challenges that led to other operational inefficiencies. The majority of the balance is that kind of airfreight premium freight that we've been incurring. We kind of expected that cost to come down, of course, as the year progresses, guiding to $60 million in the second quarter. I would say that we have continued to face meaningful tightness even here in Q2. It feels a bit like maybe you solve one problem and then another problem pops up, which I'm sure Mahesh can attest to. And so hopeful that the rest of Q2 improves a bit, but it is, I would say, still very tight. And of course, that's causing elevated cost levels even with respect to the guide as we do everything we can to meet demand for our customers. The other thing I'd highlight is just that, as Mahesh indicated, India is a very important market for us from a revenue standpoint, it's also a very important market for us from a supply standpoint, really, especially in our power systems market. So we'll keep an eye on that situation, and that could be could be an area that causes some increased costs as we look to mitigate our business impact there, but a little too early to call just yet.

That's really helpful. And Mahesh, in your prepared remarks, obviously, you're noting a very strong demand environment and some supply chain constraints. Just given the OEM production rate has kind of been slower to pick up, is anyone asking Cummins to kind of delay engine shipment levels just because they're not back to kind of where they want to be?

No, we are seeing elevated levels. We do see disruption sometimes, an hour, sometimes a couple of hours, sometimes a day. But by and large, for the month, we do see OEMs pick up the products that they have ordered off us. And our guidance is -- factors in the disruptions we are expecting from our customers. So I would say, overall, the demand is pretty robust and customers are picking up as long as -- I mean to the demand expectations that they have put on us.

And so are you seeing any sort of worsening bottlenecks from either second or third tier suppliers right now?

The bottlenecks keep moving. It's still around the semiconductor chips. I think, in Q3, I'm sensing sensors is going to be the biggest bottleneck for us, but it's again around semiconductor chips. Previous -- earlier, it was blocks and heads, then it was ECMs, then it is sensors. So we just keep pushing the ball out. I would say it's no different than every quarter we start, Rob, and we just have to keep working it day by day to debottleneck the issues and hopefully just keeps arriving for the next month.

Yes. We heard that yesterday in our [ Shipper ] panel. Everyone's really struggling to -- across all modes of transportation right now. And Mahesh, this kind of follows an investor question. The investor is curious if you think OEMs are building inventory of your Cummins products to avoid being cut short later in the year, just given how strong demand is today.

Yes. We are not seeing inventory buildup, but I think I'll let Jack comment -- with the exception of China NS V, where we were expecting a prebuy, we are not seeing inventory buildup, but I'm going to let Jack address that in a little more detail.

Yes, that's right. I mean I think, in China, we've seen a fair bit of inventory buildup, not as much visibility in that region, of course, but we have seen some inventory levels increasing as the OEMs begin to increase production of NS V and then to liquidate that inventory amount once the -- as some of the registrations for regulations have been extended. And so we've seen it in China. The U.S., not quite as much. You obviously saw some various production cuts announced in -- from some of the plants in both Europe and in the U.S. Now those are driven by some other supply categories or suppliers, I just said, not us. So we haven't seen a ton of inventory build just yet, but we'll see. It's very healthy dynamic in the industry. That's for sure.

Maybe, Jack, can you kind of give us a little bit more context in terms of the magnitude of the inventory build you're seeing in China? How much happened in kind of first quarter? Is that continuing to build in the second quarter? And maybe remind us for context, during prior emissions changes in China or some of the regions that have already gone to NS VI, kind of what you saw just so we can kind of put that into context.

Yes. So generally speaking, if we look back over the past couple of years, we've seen inventory levels, hover between kind of 150,000 to 200,000 units across the major OEMs kind of the top 8 to 10. That has started to tick up, I would say, at the back end of 2020 and now is hovering in the close to 300,000 as we've moved through the beginning of this year. And so that, coupled with just normal kind of prebuy dynamics and what we generally see is a slow momentum out of the gate when there's a new regulation, is leading us to believe that, again, first half will be quite strong and second half will taper off a bit as the OEMs need to work through these inventory levels. And generally speaking, end users will be a little hesitant out of the gate to try out the new technology, which will be a bit more expensive due to the content increase. We have seen various regions, like I mentioned earlier, pushed back some of the registrations for end users when they can register a new vehicle and allow a little bit more of a grace period from when they can do that. And so basically, what that does is allow production to occur basically right up until the implementation of the new standard and then registration can continue on for a period of time thereafter. So for us, the revenue impact is that we'll, again, see a lot more activity in the first half of the year and then the OEMs will again liquidate their inventory and realize their revenue kind of over the back end of this quarter and into Q3.

Got it. And should we still be thinking about within China and India a roughly 40% falloff in the second half of the year?

Yes. I mean, overall, we think the market, from a heavy medium-duty standpoint, will be down about 15%. Originally, we thought it'd be a bit steeper of a decline. So I think that just goes to show that the first half has remained a bit stronger than we originally thought. And it's important to remember that 15% off of what was a record year in 2020. And so we're kind of moderating back to, I don't know, it's hard to call what exactly a normal level is, but moderating back to a more probably normalized level like in 2019, if you will.

And I'll just clarify that the drop-off we see is in China. Because of the NS V prebuy, we don't expect a similar drop in India, which BS VI regulations came in last year and the market just -- is continuing to recover.

And within China, should we expect that softness in the second half of the year to kind of continue into the first half of '22? Or would you expect the inventory to have been bled off and kind of back to more of a normalized year?

It's a good question. I think the one thing we can say with certainty when it comes to China is at we have been consistently off in terms of our prediction. So we'll see what happens. I mean, again, it's hard to predict exactly what the government will do to drive adoption of NS VI product. And overall, I mean, it doesn't feel like there's too many indicators around a broader economic pullback. So we'll see. I think it's important to note what happens over the balance of this year, and then we'll come back with the outlook for 2022.

That's helpful. In the past few weeks, you've announced a bunch of new or expanded partnerships. Can you discuss kind of what these agreements mean for your Engine segment? How quickly you're expecting them to kind of ramp up? And what, if any, incremental investment we should be thinking about for the company?

Yes. So I'll start kind of from an Engine standpoint and then maybe turn it over to Mahesh because it's important to note that these are also good opportunities from a component standpoint as well. So we're really excited about these partnerships. I'll take them in turn. So with Isuzu, it's essentially a partnership to provide our midrange 6.7 were used in their medium-sized trucks. So that will be first a North American opportunity, which really begins to roll on here in the second half of 2021. And then an opportunity in Japan and Southeast Asia, where we're not a very significant player today, kind of middle to end of this decade, depending on regulation and traction. In North America, that's roughly 2,000 units a year, give or take. And in Japan and Southeast Asia, probably an opportunity of up to roughly 10,000 units. So a nice growth avenue.

Could you give us -- before you go to the other recent kind of incremental wins, can you give us a sense of what parts and components that today Cummins is already providing those nameplates and what are incremental opportunities?

I can state, for Hino and Isuzu, we don't supply as much. So almost all of it is incremental. For Daimler, which was the third partnership we announced, we do supply some turbos and some components like dozers, but they pale in comparison to the content on every Cummins engine. So again, pretty significant growth from a component standpoint, especially in the medium-duty space. We have higher market shares with OEMs in Europe in the heavy-duty space, but medium-duty is good growth for components.

And if you could finish walking through the resilience with Hino and Daimler.

Yes, sure. So quickly with Hino, again, they'll offer our 6.7 and L9 engines in -- by the end of this year. That's roughly going to be, call it, 5,000 to 10,000 units a year. And then we're engaged with both Hino and Isuzu in kind of broader strategic discussions as well. So we look forward to those partnerships across a number of different areas of the business. With Daimler, it's a global medium-duty engine collaboration really across 4 primary markets. In North America, it's roughly 10,000 incremental units across the truck and school bus markets, phasing in kind of ahead of the next emissions regulation in the middle of this decade, both EPA and CARB. In Europe, it's roughly 30,000 units, again, across truck and bus, coinciding with the Euro 7 regulations, which will most likely occur here in the middle of this decade. And then in Brazil, it's roughly 40,000 units beginning kind of at the latest with the next emissions regulation, most likely towards the end of this decade for use both in the Brazilian end market as well as export to some other countries in South America. And then in India, 25,000 to 30,000 units, again, beginning at the latest with the next emissions regulation. And so as we mentioned investments initially, I think as we think about the broader strategy, the intent, of course, is to utilize existing investments wherever we can, right? So we're already designing emissions-compliant versions of these engines in all of these regions for other customers as well and so where we can, utilizing that same product, of course, which allows us to spread that investment across more units. And then from a footprint perspective, again, in North America, really utilizing our existing infrastructure. In Europe, we'll do a plant within a plant concept with Daimler, where we lease a portion of their Mannheim facility for production of European units, and then working collaboratively in these other regions to determine what the best manufacturing strategy is, utilizing their existing assets as well as ours. So in general, the good thing about these collaborations is it's not significant investment beyond what we would be making, and we're really excited for these partnerships and feel like it's a great win-win for both companies.

How should we think about the incremental margins as the volumes pick up across both the Engine and Components segment? Should these be better than kind of corporate average margins? Are they going to be in line like...

Yes. Yes, I mean, really, we kind of think about these more as a ROIC expansion, return on invested capital expansion, initiative versus necessarily margin percentage accretion. So we expect margins to be roughly in line with what they are today, both from an engine and compliance standpoint by region. And really, the goal here is to increase our returns on a relatively similar invested capital amount and really, again, spread the investments that we would already be making across more units.

That's helpful. Later today, there's going to be a bunch of new zero emission entrants. And Cummins has got really unique perspective with hands in diesel, nat gas, battery electric, hydrogen fuel cell. Could you discuss kind of which applications you see as right for the different zero-emission technologies?

Yes. Thanks, Rob. So the most likely applications that move to BEV are bus and the lower end of medium duty, typically because they have shorter range cycles and they return back to the same base, and so charging becomes easy. And so we do see these applications will move to BEV probably at a faster rate. A lot of our applications in heavy-duty, like long-haul heavy-duty trucks, we see is really good for fuel cells long term, primarily because of the energy density that you require for payloads as well as the range that you can travel with the fuel cell truck. And when I look at components, overall, even with these new technologies. I think we have least content on a BEV. But any other technology, whether it is natural gas or hydrogen or hybrid, we tend to have a fair share of the content. In hybrids and future diesel emissions, we grow content. In hydrogen and natural gas, we have enough content, not as much as diesel, but still substantial. So as I look at components over the next decade, I still see good growth ahead of us, primarily 3 levers. The first one is increased content with the pending regulations, China and India, and then we have some other markets still pending like Brazil and Euro 7. Share gains, Jack spoke about some of the share wins we've had alongside the Engine business. And then the AMT product that we've launched through our Eaton-Cummins joint venture, is doing really well in China. We are just launching it in China, and we expect that to continue to grow share in that market as adoption increases. So overall, while I do see internal combustion engines will be replaced, I think we still have good growth ahead of us and actually a long tail with the different technologies with the exception of BEV. For the BEV market, we rely on a New Power business for them to invest and try to get a share of OEM's business through that business.

That's helpful. And maybe can you give us a sense about that $600 million in terms of incremental emissions opportunities that you expect to capture in China and India over time? How much should we expect to kind of hit the revenue base in 2022? And maybe how quickly do you see this kind of scaling up?

Yes. So the scaling up started last year, and Jack can provide exact numbers, but the scaling up started last year with India going to BS VI. China had partial NS VI. Most of the scale-up happens this year. So between last year and this year, we would -- I think we'll be close to about $500 million of the $600 million, and the remaining will materialize by '22 as China goes to all regions NS VI, right? So we're pretty -- we're tracking to the $600-plus million number that we had given, and most of it gets realized by 2022.

That's helpful. And is that $600 million, is that kind of an average over the cycle? Or is that what you should be generating kind of at the low or at the high end of the cycle?

It's an average market size. There are cycles. But on average, we expect to see about $600 million growth mostly through content and some market shares. That should sustain, on average. In good years, it should be more. In recession, it should be less.

I guess, Mahesh, you're talking about longer-term hydrogen fuel cell kind of making sense for heavy-duty applications in truck. I guess as we're kind of bridging between today and whenever that long term, I'd be curious when you think that long-term transition happens, maybe could you discuss renewable natural gas, renewable diesel and how you see those strategies kind of playing out over the next few years.

So we are seeing more and more need for more and more sources of fuel. So we do see renewable diesel, our engines and components are -- can work with them today. We are seeing natural gas grow. It's only 3% of the market in the U.S., but the big area for us for growth in natural gas is really China. We're seeing a huge adoption of natural gas in China. We are seeing interest in hydrogen and -- sorry, coming back to natural gas, we have good shares in natural gas, and we expect that because of those good positions, we should be able to get a fair share of, the market, both in China and as it grows a little bit with CARB regulations in the U.S. Hydrogen, we are seeing some interest in hydrogen, ICEs in Europe and China, and we are -- again, it's tailoring of the existing architecture we have. There is some investment, but not a whole lot, that we are working on. And then fuel cells, long term, where we continue to either invest or acquire new technology through our New Power business, right? So we see a play in all these technologies and the need for multiple technologies just based on local regulations by country. Like I mentioned, China is anchoring more on natural gas than other parts of the world. Europe is thinking of hydrogen ICEs and fuel cells. So we're seeing -- renewable diesel is coming up in certain parts. So we're seeing a plethora of ranges of fuels, but the good thing is most of our technology can be tailored for these applications.

I'm mute there. That's actually a good segue, Jack. Earlier in the week, you guys announced a new electrolyzer in Spain. Maybe can you give us a couple of thoughts in terms of what that means for the New Power segment and how quickly you see this ramping.

Yes, absolutely. So it's really kind of 2 key announcements. So first, we basically have agreed with Iberdrola to embark on our partnership to deliver large-scale panel electrolysis to the market. So Iberdrola has obviously a vast utility operation both in Spain and broader Europe. And so a lot of interest in building out the hydrogen infrastructure, and we're really excited to partner with them. This anchor project is going to be a 230-megawatt electrolyzer going into the green ammonia for fertilizer market. But we feel like it can really prove to be a good benchmark for the capabilities of large-scale panel electrolysis and really serve as a blueprint, if you will, for other projects and operations down the road. So the first piece is the partnership with Iberdrola. And then the second piece is essentially the build-out of our capacity and footprint. So we'll be putting in a -- what will be initially a 500-megawatt capacity facility in Spain with the ability to scale it to 1 gigawatt. We're excited about putting that facility in Spain. And Spain, of course, has a lot of ambitions to expand their hydrogen infrastructure, as do some other European countries. And so we're excited about the art of the possible in terms of how Cummins can participate in that build-out of the hydrogen economy in Spain. And then we also think that there's potential that Spain can be a significant exporter of green energy into the rest of Europe and abroad because of their extensive solar and wind capabilities. So we're really excited about it. We've been kind of hinting a number of partnerships that we've been working. So this provides us a chance to really get a strong foothold in the European market, which, in combination with China, we see as really the leaders in terms of adoption of hydrogen. And then we're also really excited for the prospects in North America as the interest only continues to increase. So a lot of momentum in the New Power business, in particular, on the electrolyzer side, so we're really excited about it.

Clearly, there's a lot of exciting stuff going on at Cummins today. Unfortunately, we've reached the end of our time, and we'll be continuing the transportation conference shortly with Fortress in a couple of minutes. Jack, Mahesh, thank you again for participating. I look forward to catching up soon.

Thank you, Rob.

Bye.