Cummins Inc. (CMI) Earnings Call Transcript & Summary

Okay. Good morning. I'm Steve Fisher, UBS machinery, engineering and construction analyst. We're really pleased to have Cummins with us to start off day 2 with Jack Kienzler, Executive Director of Investor Relations. We're going to run this as a fireside chat. There are no slides. You can use the question function to post questions, and we can address them during this session. Now before we get started, as a research analyst, I'm required to provide certain disclosures relating to the nature of my relationship and that of UBS with any companies in which we express 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 Jack, thanks very much for joining us here.

Just to kick off here, when we last spoke a couple of weeks ago, the near-term message was that costs were maybe not coming down as fast as you would hoped and that you expected Q2 to look maybe similar to Q1. A little bit more time has passed, anything changed in the messaging around that kind of cost dynamic?

Steve, thanks for having me, and thanks, everyone, for your interest. Yes. I mean, I think really we've continued to see a lot of pressure in the supply chain. It doesn't feel like many different supply sources are sort of dried up. And importantly, the order of cadence and demand has not subsided. And so we continue to expect really the supply chain constraints to last probably for the balance of 2021. I would say we're optimistic that the costs associated with those constraints will begin to hopefully ease. We have anticipated sort of a sequential improvement quarter-over-quarter. And it feels like, based on the way Q2 has unfolded thus far, that the cost will be still relatively high, especially from a premium freight standpoint in Q2. And really, it's just a balance of we're trying to do whatever we can to continue to meet our customers whatever we can and do whatever we can to fulfill their demand. So there, obviously, is just an inherent cost associated with doing so. And so I think we have guided our premium freight figure and supply chain costs for roughly $105 million in Q1, we expected closer to $60 million in Q2 and again, improvement into the back half of 2021. It feels like there's a fairly good chance that those costs will be higher than our expectations in Q2. And then, I guess we'll see what happens in the balance of the year. Hopefully, there will be a little more transparency. But in my discussions with our supply chain team, it certainly is still a pretty dynamic situation.

And if you had to kind of say -- I mean, it sounds like the majority of that is more in the premium freight side. Are there any other costs that are really driving that? Or how much is freight versus other things?

Yes. The bulk of that cost is really the premium freight. There are some other costs, inefficiencies, if you will, that we experienced when you've got lack of importance. For example, an increase in overtime and lack of productivity at some of our plants as you're waiting for certain parts that you need for assembly. And so that's another piece of it, yet, the bulk of it is certainly the premium freight figure.

And how much of this are you experiencing in North America versus the rest of the world?

Yes, it's definitely a global issue. It's certainly been felt more, I would say, on the on-highway markets. Part of that is just due to the number of units there compared to some of the off-highway segments. But -- and so it's primarily an engine business issue as well as some in the Components business, less so Power Systems business, although we are seeing some backlog there. So really a global issue, not limited just to North America. Certainly seeing a lot of pressure in China, seeing a lot of pressure in India as well. Obviously, some other dynamics there going on in Q2 with the unfortunate second wave of COVID cases, but really global issue. And we're doing our best to try to meet demand where it exists in all of our regions and weather the storm as much as we can.

Makes sense. Now this becomes not just a 2021-type issue. I'm sure it's spurring some discussion strategically throughout management of, okay, well, how do we manage this in future cycles. What are the lessons from the supply chain challenges post-COVID? And what -- how might you do things differently?

Yes. I mean, I think as we've been embarking, not only because of the current supply chain issues, but certainly, when we had various tariffs in place, we've embarked on a few different supply chain initiatives. One of which is to try to localize supply as much as we can so that we don't have to incur significant premium freight bills, flying things from one country to another. In today's world for -- in order to best optimize our exposure to tariffs and whatnot, there's always a balance there, of course, with looking at where the suppliers are located and trying to localize where it makes sense and trying to be mindful of your purchasing strategy and from a low-cost country standpoint. But -- so that's something is just trying to localize , I'd say, production where it makes sense. And then, importantly, making sure that you're dual-sourced, or you've kind of hedged some exposure where you can. This one has been particularly challenging because it's not even our supplier base, for example, but it's your suppliers' suppliers. And so you're trying to take a lens as far through the value chain, if you will, as we can and identifying various exposures. There's a lot of strategic work going on by our supply chain team, and hats off to them for being able to mitigate it as much they've been able to so far, and we'll continue to evaluate strategic alternatives to help us be better positioned moving forward.

Do you think that necessarily means a lot more to be supplied within the United States?

It certainly could. You've obviously seen some -- it feels like some government incentives and whatnot to try to localize supply. The Biden administration has met with several industries overall, but -- including our own and our own leadership on -- to try to get a better sense of what's going on, in particular, with the semiconductor issue and how do we, I would say, reduce our dependencies on other regions moving forward. So we're supportive of that. And we're also supportive of a free global trade environment as well, though. So I would say that it's certainly possible that we would see an increase in North America content moving forward and optimistic, though, about the potential for broadening our -- in optimizing our supply chain on a global basis as well.

Sounds good. Now shifting gears a little bit. One of the areas of strength in the first quarter was China. And I guess, I'm -- you still hold a little bit of caution for that market in the second part of the year. Have you started to see the market turn there as you expected? Or is there hope that, that market could hold up better than expected even further?

Yes. So I mean, a few different things to highlight. So truck demand, I would say, has remained quite strong even as we've begun the second quarter. A lot of that still is driven by NS V demand and pre-buy ahead of the implementation of NS VI regulations in July. We've continued to see inventory levels increase. We kind of monitor some of the top OEMs and work closely with them on production scheduling and whatnot. And we've seen inventory levels tick up a fair bit, I would say. Some of that, from our understanding, is driven by the potential of that -- some registration regulations, if you will, on NS V vehicles will extend into Q3, enabling the OEMs to sell their NS V inventory beyond the June cutoff. And so for us, as their supplier, that drives pretty good strength, I would say, in the first half. And the implications are that Q3 will dip down as they liquidate their inventory balances. And then we expect to see some slow activity out of the gates on NS VI. It still feels like the industry is trying to understand what the economics of an NS VI vehicle will be and understand what the underground demand is there. So yes, I do think it's a second -- first half, pretty strong. Second half, we'll start to see some weakness. We're starting to see orders come in a little bit as well. So we continue to think it will be a pullback from what was a record year last year. And again, Q1 was quite strong. we expect Q2 to be fairly strong and then see it taper after that. I think that's both what we're seeing on the on-highway markets, but also in -- from a construction and excavator standpoint as well.

And what about market share? Any particular changes on the on-highway and the off-highway side? I get a sense of your local brand customers on the off-highway side are gaining share. Where do you think they would be on the on-highway side?

Yes. We continue to see, I would say, good positive trends on both the on- and off-highway side. Generally speaking, when we see new regulations come into play, a lot of the smaller OEMs tend to cede some share to the larger OEMs due to their ability to bring that more stringent technology product to market. And so that, of course, benefits us as we have a number of joint ventures with the largest OEMs in the on-highway space. We've also seen an increase in our penetration with our existing OEMs as they -- as our products have performed well, both on the engine side and the component side and has boded well for our business. Our penetration with Foton has increased, and Dongfeng remains strong as well. So it's kind of a multifactor calculation to get to market share, but it's remained, I would say, pretty strong. I think as the market evolves, we feel like there's more positive momentum to come. Natural gas interest and demand, we feel like, will continue to increase in China. And we plan to continue to bring strong products in that space to the Chinese market, which should help our overall share as well.

Great. I wanted to maybe shift gears a little bit to some of the multiyear revenue opportunities that you have with some of these new agreements. Can you just talk a little bit about where you stand with ramping up Hino, Isuzu, kind of Daimler medium-duty? What are the milestones that we need to be -- that we should be looking for here?

Yes, absolutely. So first, on the Hino and Isuzu side. So in North America, we'll start to do activity with both of those customers in North America beginning in the second half year of 2021, with 2022 as sort of a whole ramp year. We expect that to be roughly 2,000 units, give or take, with Isuzu and a bit more with Hino. So nice incremental opportunities for us and some nice opportunities for those important customers for us as we give them our market-leading product in the medium-duty segment here in North America. With Isuzu, we expect to see volumes begin to flow in Southeast Asian market in the kind of middle of the second half of the decade. We're optimistic about that. That's a region where we haven't been a significant player historically. And so that will be a nice incremental opportunity. And the discussions thus far with Isuzu went -- have been quite positive, both in terms of the medium-duty partnership but also trying to identify other areas of strategic collaboration more broadly. With Daimler, it's a bit of a regional cadence, if you will, and it will coincide more with next-generation emissions regulations than with those other 2. So in Daimler, in North America, it will coincide largely with the emissions regulations from our perspective in 2024 and then broader EPA perspective in '26, '27 time frame. Importantly, though, we're already integrated into their vehicles here in North America. And so you could see potential for a phase-in approach, but largely coinciding with the North American next-generation regulations. In Europe, it will coincide with Euro 7 emissions regulations, which haven't been finalized yet, but likely to come in the middle of the decade as well. And then, from a rest-of-the-world perspective, in India and Brazil, those opportunities will likely coincide with next-generation emissions regulations in those regions as well, which will probably happen in kind of the later part of this decade, maybe the 2028, 2029 time frame.

So sorry, just to clarify, the 2,000 units that you mentioned with Isuzu, what's the first time period for those to be expected?

Yes, that will start to flow in here in the second half of 2021 and fully ramp again into 2022. That's -- it's just dependent on their -- each of these OEMs kind of market shares in the North American region to get to exactly what that volume figure will be.

Got it. Okay. Now shifting to the Components, you had a really strong quarter. And how should we think about modeling that segment in the medium-term outside of just the general truck cycle? What does that demand curve look like as you have some more areas where you're operating those products?

Yes. So it's kind of on a regional basis as well here. So in North America, I think there's -- obviously, it was a strong Q1 and expect it to be a strong year overall. That's largely -- will be dependent on the overall market cadence based on order activity, potential for improvements over the course of the year, but that will be dependent on the supply chain interest rates just as it will be in the engine business as well. If I think about the other regions in the world, China, from a Components standpoint, hits the revenue line whereas in the Engine business, it's more of a JV income story. So we do expect to see a decline from overall market standpoint in the second half, as I just discussed, as we see in NS VI regulations. Now some of that will be offset in Components because of the content expansion. And so with more stringent emissions regulations from the after-treatment perspective, there's more content, and there's more opportunity for the Components segment. And so that will offset some of that volume decline, kind of to be determined exactly what that dynamic will look like. It depends on how strong NS VI adoption was in the second half of the year. If I think about some other areas to highlight, we've seen, at least, in Q1, we saw a continued strong demand from an after-treatment perspective in India as that market picked back up. They have their equivalent of next-generation emissions regulations rollout in April of last year, although it's amid the overall pandemic uncertainty. And so as that market picks up, we'll continue to see the benefits of that content expansion in addition to some of the share gains that we've had in that region. And then, as I think about other areas of Components growth, certainly, we talked about the various Engine partnerships that we've announced. Important to note that those aren't just Engine opportunities, those will be areas of expansion for Components as well. Generally speaking, if it's our engine, many of those component categories will see that same volume opportunity as well. Things like after-treatment systems or turbos or filters, for example. And so that will be a nice growth opportunity over the medium- to long-term for Components. And then, in addition, we've continued to see demand for our transmission product with the Eaton-Cummins joint venture be quite strong. We've rolled out that product into the market in China as well and have seen strong adoption of our product as well as automated manual transmissions overall. And we've been pleased with the cadence of adoption of those. And so that's a nice opportunity, both from a revenue standpoint but also from a margin standpoint to bring that subsegment of Components more in line with the overall segment.

Sounds good. And so $2.1 billion of revenues in the first quarter. Your guidance implies a $1.9 billion plus or so per quarter on average for the rest of the year. It sounds like maybe there's some conservatism in there depending on how supply chain goes.

Yes. I would say it's largely dependent on supply chain, which is, again, a global issue. But I think it's certainly constraining the potential or upside in North America a fair bit in 2021. And then, it will be really dependent largely on the India and China market in terms of how the sequential cadence goes from a quarterly perspective. I think it's fairly obvious, but reasonable to expect a pullback in the India market here in Q2 amid the uncertainty. We're hopeful we could start to see -- that we've seen positive trends from an overall new case perspective. We'll see, hopefully, that bodes well from an economic perspective as well as we move into the back half of the year. And then, in China, it will just depend on how the new emissions regulation impacts the overall volumes. So those are kind of the moving factors and why it felt like Q1 was probably stronger than we may see over the rest of the quarters.

Got it. Maybe shifting gears again a little bit to talk about some of the other markets. Data centers, it's something we hear a lot about. Still being very positive. What are you guys seeing in both the North American markets and internationally? I think it's still pretty strong for you guys. Not sure where you're seeing more runway, if it's in international or domestic. Can you talk a little bit about that market?

Yes, absolutely. I mean, data centers have really been a bright spot, I would say, in the overall power generation business. Some of those markets, if you think about not being correlated to them, residential construction have been somewhat stagnant over the past -- over the course of 2020, I should say, and in 2019. But the data centers have continued to be an area of growth over this period. So we expect demand to be up roughly 15% again this year. Continued strength in China. Certainly, an increase in activity in places like India and the overall Asia Pacific markets. And in North America, it still has been fairly strong market as well. And it feels like in North America, that may be -- it gets slower perhaps than in China, but it feels like it's more of a project timing-type consideration versus a sign of underlying demand slowing. So we're optimistic, certainly, for this year and into future periods for strong medium-term growth, for sure.

And what about oil and gas and mining? Obviously, we're in a higher commodity price period right now. Is that market starting to show any meaningful sign of improvement?

Yes. Oil and gas, I would say, relative to our expectations, has recovered certainly slower than some of the other industrial applications. It's a fairly small use of our business, overall, largely engines going into the fracking environment. And so we haven't seen that pick up quite as much as we expected. Overall, we had thought that may be up roughly 50% over a relatively low base in 2020. It feels like that's probably closer to 20% to 25%. But again, a fairly small piece of our overall business. Mining, on the other hand, has really picked up, I would say, quicker than we expected, certainly at the beginning of the year. We're seeing an overall strong commodity price environment leading to a pretty quick recovery in some of the mining applications. Strength in copper, iron ore and coal price is guiding growth from both putting existing units back into service, which helps drive some parts flow and rebuild activity, but also as capital budgets have loosened, it's driven good momentum on a first-fit basis as well. So we're optimistic that 2021 will be quite strong from a mining perspective, and hopefully, continue its strength and demand into next year as well.

So I guess, if we had to step back and just kind of summarize 2021, there are some potential sources of upside, some potential sources of risk. Can you just maybe kind of summarize which are the areas you think are the revenue upsides and risks and maybe the margin upsides and risks?

Yes. So I would say, if I think about on a regional basis, North America, I would say, across the board, both on-highway and off-highway across our businesses, demand remains strong. So depending on what happens with the supply chain, I would say that's the biggest kind of swing factor in terms of opportunities versus risks to our guidance. If supply chain constraints ease in the back half of the year, then there is some potential upside to the revenue line. And certainly, that would lead to an easing of some of these inflated costs that we're seeing, which would be, of course, a benefit at the margin level. If I think about then in China, again, it's kind of a -- we feel like a first half, second half-type story, even more so than it typically is. And so if demand for NS VI products comes out of the gate stronger than expected and if the excavator market hangs on more so than it otherwise may, then that could be a nice opportunity. On the other side, if it's slow out of the gate, then that could be a bit of a risk. And then, in India, I think it will be a bit up and down as the year unfolds. Obviously, Q1 was quite strong. We expect Q2 to be fairly low based on what is happening on the ground there. But if we can get the pandemic under control, then hopefully, the economy will continue to show signs of improvement and nice cadence into the back half of the year. And then at the margin line, the only other thing I'd highlight is outside of maybe supply chain, hopefully Eaton and China potentially weakening over the year is just some of the dynamics at our warranty line. Important to remember that Q1 included kind of a onetime change in estimate to the tune of $44 million, $33 million of which was in Components, and $11 million of which was in Power Systems. Those are not expected to repeat as the quarters unfold. And so you'll see a bit of a tick up in those expense line items as a percent of sales, which is obviously a headwind if you're trying to annualize Q1 and think about a full 2021. Nothing alarming there, just a bit of a onetime that we don't expect to repeat.

Got it. So then maybe thinking about cost structure a little bit longer term. Obviously, at the end of 2019 and very early in 2020, pre-pandemic, you had a cost restructuring program, $250 million to $300 million. I think it was that presumably is all completed now. Any more opportunities you guys are seeing for structural cost reductions?

Yes. So yes, those were largely realized and complete by Q1 of 2020. There haven't been any major structural changes beyond that restructuring. Obviously, we did some temporary actions particularly at the headcount -- not headcount, but compensation line items in 2020, which we've talked about. But if I think about broader structural changes, a few things potentially come to mind. Obviously, if you think about just COVID impacts overall, we have seen continued low levels of certain SG&A line items like travel. I don't know, that's obviously not going to continue at the pace it's been over the course of 2020 and 2021. But it does feel like perhaps over time, we may manage the business a bit differently and you don't see the travel expenses that you have historically. We're also looking at different ways to streamline and modernize some of our kind of shares to risk categories, things like HR, IT, finance to provide that kind of cost-effective support as possible. And so we're looking at some of those categories and looking at different ways that we can streamline that work. And then, finally, as we've shown in our distribution business, there's some different transformation efforts that we have been successful in employing here in North America that hopefully, we could leverage on a global basis in that business unit. Things like changing the administrative structure, but also importantly, trying to drive more points of service and product offerings in our various channel locations, which should help improve not only top line growth, but also some margin opportunities in that business.

What's the timing you think of sort of the international or outside of North America distribution improvement opportunities?

I would say that we're trying to really focus on just given the materiality of North America from a distribution standpoint to the overall. We're trying to, I would say, finish up some of the transformation-type activities. Those have been slowed a bit by some of the challenges that we've experienced from a supply chain standpoint, parts availability, for example, in distribution. And so I think we'll focus -- continue to focus on the North American region and then leverage those, hopefully, more globally over the later part of 2021 and maybe into 2022. It's early days, yes, but...

Got it. Okay. Moving on to the New Power segment. What would you say are the top priorities for the New Power segment over the next 12 months?

Yes. I mean, overall, I would say it's trying to get as much kind of cadence at the partnership line and units into the field overall. Those partnerships are critically important, in our view, to again, to get units in the field, to get discussions with customers on an ongoing basis, and discussing units that are in real-world applications and not just in test cells of location, for example. And so on the electrolyzer side, we think that that's a variety of different partnerships that we can pursue. We announced our commercial partnership with Iberdrola, I guess, it was last week in Spain to pursue some large scale PEM electrolyzer opportunities. Earlier in the year, we've announced an MOU with Sinopec to pursue similar types of projects in China as well. And I think we'll continue to employ our best kind of web of relationships and leverage our long-proven history of working with other companies to gain market access in the electrolyzer space, certainly, both from a commercial standpoint and then also thinking about how we build out capacity to service that demand given the pace of orders we're seeing. On the PEM -- or on the fuel cell and battery electric space, I think it's just continued pursuit of getting units into the field in markets that are adopting and pursuing various partnership potentials and just overall customer supplier relationships. Those markets are moving quicker in some applications than others. But overall, we feel like it's really important from a strategic standpoint to get as many units into the field as possible. That not only allows us to continue to build on our existing commercial relationships, but also get units in the field, learn from how those units are performing and then continue to iterate on next-generation products so that we're best positioned from a technology standpoint to be a market leader in a number of different applications, particularly those that are our core markets today when they adopt in a more meaningful way.

Makes sense. Can you talk a little bit about how the competitive dynamics have been evolving since you've owned Hydrogenics? I think when you had your Hydrogen Day and you put out a target and it was an assumption that all the competitive players would get their own fair share. How are you seeing the competitive dynamics shape up?

Yes. I think one of the reasons why we really liked the Hydrogenics business is they had a lot of units in the field, both on the electrolyzer side and on the fuel cell side. They were pursuing a number of different applications to try to see how that product fit in different duty cycles and end use cases. We've been able to build upon that, both in terms of large-scale investment to continue to iterate on the technology, but also utilize the broader Cummins channel and customer relationships to bring that technology to the forefront of discussions with other large-scale providers in the market and to continue to improve those technologies by utilizing our application knowledge in our core markets like on-highway trucking, for example, or some of the other off-highway applications. So I would say that the biggest piece is kind of adding a proven, well-capitalized owner to the equation has perhaps opened the door for various partnership-type discussions, much like the Iberdrola one has shown, right, where I think adding Cummins to that equation has given that partner and the overall Spanish government comfort, if you will, that we'll continue to invest in that region and in those commercial applications and staying behind that partnership as we work towards developing what we feel like, hopefully, could be a benchmark for large-scale PEM electrolysis.

Great. There's obviously a lot going on behind the scenes, and I know you were involved with a lot of the business development activities and over the last several years in your prior role with Cummins. Can you just give us some insights on how some of these partnership discussions tend to go? What types of companies are turning to you for partnership? And which ones are Cummins turning to? And how do those discussions tend to go?

Yes. So I mean, generally speaking, across our whole business, we've, I would say, demonstrated a really strong ability to partner, whether in a joint -- in an equity joint venture or in just a broader kind of customer-supplier-type partnership with many different market-leading companies across a number of applications. We generally, in China, for example, pursued partnerships where we can bring a technology leadership position and our partners can bring market access, if you will, in volume and scale. And so that's been an important growth avenue for the company historically, and that's really what the likes of the Sinopec and the Iberdrola agreement have continued to highlight, is our ability to bring that technology to the forefront and continue to innovate and also learn from our partners in terms of what they're looking for and what technology is best fit with their needs. I would say that, that kind of year-over-year ability to do so as it continues to open doors for Cummins and our ability to have really strong cash flow and market knowledge, if you will, across a number of applications can differentiate us against other potential partners. So I would say that we will continue to focus on a number of key markets, certainly in the electrolyzer space, looking at regions where we feel like adoption is going to occur sooner rather than later and then leveraging that technology into other areas of the world as they adopt, although perhaps a bit later, right? So that's why we pursued partnership opportunities in Europe and China. We're enthusiastic about the interest in hydrogen production and consumption overall in North American markets as well. And so that feels like it could be an opportunity sooner rather than later on the electrolyzer side. And in the on-highway space, we've demonstrated, I would say, good traction with important customers in the transit bus and school bus segments. And hopefully, we can leverage those technologies and application knowledge into some of the other higher volume markets that are going to be important to us like medium-duty and heavy-duty truck, for example.

That brings me to actually a good point. So some of the pushback we get from investors is, well, you really have to just follow the North American truck cycle and China. And so we're seeing orders at peak in China -- or sorry, in North American truck, and China, as you guys have talked about, is coming down. Help us make the -- how would you say the bull case would be if people wanted to dream the dream beyond just North American truck and China? You mentioned bus. There's a lot -- seems to be a lot of activity potentially ramping up on the bus side. You got data centers, oil and gas, mining. What should be investors focused on beyond just that North American truck cycle and China if they wanted to kind of have a more constructive view of Cummins from here?

Yes. So I would say, broadly speaking, the 2 main areas of growth, in our view, are, one, is continuing to improve our market share and outgrow our markets not only in North American truck, but also in the European truck and more global truck environments as demonstrated with the partnership and announcements with Hino, Isuzu and Daimler. We expect and are hopeful that more of those will come, which will allow us to broaden our geographic footprint, if you will, into Europe, where we've historically been somewhat of a niche player and continue to build on our strength and in the markets in India and Brazil and even North America for that matter, both in medium-duty and heavy-duty. And then the other avenue, broadly speaking, is the New Power business. Those technologies will certainly play a significant role in our traditional core market type, the truck segment, but it also opens up opportunities to have more outgrowth in markets that historically haven't been all that material in the overall Cummins landscape. Things like rail, where we've seen really good traction with our partner, Alstom, and a lot of interest from others. And rail has long been a market that we've played in quite strong in the Indian market, and that could be a nice growth vector for us. Things like the electrolyzer space, where that's a piece of the value chain that we haven't historically played in. So I think -- and then, you mentioned mining and whatnot, the continued strength in markets like that. I think the good thing about Cummins is we have our -- a lot of different growth vectors ahead of us. And so we're excited about all of our different markets and our ability to continue to iterate on market-leading technologies and hopefully, turn those products into market-leading positions across a number of different segments, not just the truck markets in North America and China.

Terrific. Well, I think we've reached the end of the time. And so I want to thank you, Jack, very much for your time and insights. Really appreciate it. If anyone has any questions that we did not get a chance to address, feel free to reach out, and we will get them addressed.

Very good. Thanks, Steve.

Thanks so much.

I appreciate your time, and thanks, everyone, for your interest. .