Cummins Inc. (CMI) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Courtney Yakavonis, Morgan Stanley's U.S. Machinery Analyst. Before we begin, please note that for important disclosures see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. And next up, we have Cummins, the leading engine manufacturer for commercial truck, off-highway equipment and locos, who's also doing a ton of investment right now in hydrogen and battery electric. We are very fortunate to have with us today Jack Kienzler, Head of IR; and Matt Ruch, Manager of IR. Jack and Matt, thank you so much for joining us virtually today.

Thank you, Courtney, for having us, and thank you, everyone, for your interest.

And so we're going to kick it off with some questions. But for those of you who are joining us via webcast, please feel free to submit questions, and we will get to them. And Jack, we're going to kick it off with supply chain and logistics costs. So obviously, I'm sure your favorite topic today. You've been very transparent about the headwinds since the beginning of this year though the situation has deteriorated versus your original expectations. So can you just give us an update on the situation as you see it today? What components and parts of your supply chain are most impacted? And when do you think that we'll start to see some relief?

Yes, absolutely. So as you said, supply chain and logistics costs remained elevated in the second quarter, which caused us to increase our guidance from the cost that we'll be incurring. We do continue to face significant constraints in the supply chain. The main parts are, the one that gets all the headlines is semiconductor chips, but we've also seen some constraints as it relates to actuators, wiring harnesses, various sensors, block and head castings really coming across the board. Despite these significant constraints, we are, I would say, cautiously optimistic with an emphasis on -- cautious perhaps with respect to chips. We have seen perhaps some light at the end of the tunnel, which causes us to be somewhat optimistic that the situation will improve. But we don't think it will fully alleviate over the course of '21 or even into '22. We do continue to leverage our global footprint and have really put an emphasis on meeting the needs of our customers, both from an OEM perspective in the first fit as well as doing our best to fulfill end user demand in the aftermarket. In terms of costs, we do expect some easing of the costs as we move into Q3 and Q4, in line with the guidance that we issued at the end of Q2. We have seen some improvement as the third quarter has begun. And so we still estimate that for the full year the incremental logistics costs will be $295 million, which reflects about $50 million to $55 million in Q3 and about $40 million to $45 million in Q4. We'll see if it reduces to that amount, but we are, I would say, optimistic and do expect that it will decrease from the levels we experienced in Q1 and Q2.

Great. Just on semiconductors specifically, is that where you feel like there's the light at the end of the tunnel? And can you just talk about whether you think this is more of a supply issue or a logistics issue? And any other steps that you've taken to mitigate it because I think you had talked about buying in the aftermarket channel earlier this year?

Yes. So it's really been a multi -- combination of multiple issues. First and foremost, there was a bit of a bullwhip effect as demand cratered in Q2 of last year and chip allocation was given to other industries. We then saw a pretty sharp increase in demand. And essentially, the supply base wasn't able to keep up as it relates to chips. We've seen due to subsequent COVID issues in key supply sites, Malaysia being the most recent example to point to, which have continued to constrain supply. And then there's been a number of other adverse conditions, whether it's adverse weather conditions here in the U.S. as well as the port and shipping issues that you referenced. We continue to, I would say, be optimistic. But again, there's a little light at the end of the tunnel, but that doesn't mean that the situation will be resolved anytime soon. It will probably take a significant amount of time to catch up and recover fully. We have done everything we can to be creative, whether that's buying chips in the aftermarket or leveraging chips from 2020 vintage years or other years to try to be creative and continue to get the product out the door under whatever circumstances necessary. So we make a conscious effort to try not to be the person who shuts down the OEMs. And thus far, we've been successful in doing so, albeit under, as we mentioned, some pretty high incremental costs as it relates to premium freight. So we'll continue to navigate the situation as best as we can. And we continue to think that it sort of will keep a cap on what the industry is able to do from a production standpoint through the end of 2021. But all things being equal, that hopefully should lead to a significant market demand for 2022 and an overall strong year from a production standpoint.

And have you seen these impacts pretty equally between your on-highway and off-highway business? Or is this urban on-highway issue? And can you also just address -- it seems like most of the costs that you've been guiding to have been with respect to logistics and freight, but any material inflation specifically that you're seeing?

Yes. So it has certainly, I would say, been a bit more pervasive in the on-highway segment. We have seen our fair share of supply constraints in the off-highway segment. But I think, it's hard to say exactly why, but volumes are generally lower in the off-highway segment, and they just haven't seen the same chip demand that we've seen in the on-highway segment. There are some other supply chain constraints that we've been dealing with. We mentioned metal market inflation among other costs which have been elevated and continue to elevate throughout the year. So from a metal market standpoint, we originally guided to a 50 basis point tailwind year-over-year from a net price cost standpoint that has come under pressure as the year has unfolded. And we now think that that's probably more in the range of 30 basis points. We continue to keep an eye on that, and we'll update guidance accordingly as costs continue to fluctuate. But we've done what we can and continue to try to do what we can in terms of price adjustments, particularly in the aftermarket. We continue to utilize our hedging programs for various metals and precious metals, where we have some of those contractual mechanisms in place. And we'll adjust our pricing accordingly in line with our contracts as we move into next year. So we'll continue to face those headwinds. Labor and absenteeism has been a challenge as well. But I would say that semiconductors are probably the -- has been the biggest challenge followed by some of the metal market costs as we mentioned.

Maybe moving on to the North America truck cycle. I think you alluded to this a little bit before, but to what extent do you feel like some of these supply chain issues have really elongated that cycle? And can you quantify how much production was lost in 2021 that theoretically come through in 2022?

Yes. So it's definitely been -- it's definitely hampered, I would say, the upside. All the leading indicators from an end-user demand continues to be really strong. We still see a really large backlog well above replacement levels. Freight rates and underlying economics for the trucking companies remain really strong. Used truck prices also remain very high. And so all of those lead us to believe that underlying demand remains quite strong and that essentially these supply chain issues have just put a natural cap on what the industry can produce this year. We are, I would say, quite optimistic about the strength of the market as we move into 2022. It's hard to say exactly how much production has been lost or shifted to 2022. But I would say that we -- in line with [ ACT ] stocks and some other industry publications have really high expectations for next year and are hopeful that with some more time we can put some of the supply chain constraints behind us as an industry, and we think that the underlying demand is there.

Over the past year, you've announced some strategic agreements with Daimler, Isuzu, Hino to supply diesel engines for the next round of emissions regulations in North America and Europe. Can you talk a little bit about how accretive those wins are -- will be over the next couple of years, both for the early opportunity but also the aftermarket opportunity in these installed bases?

Yes, absolutely. So it's hard to say what exactly the volume will be over the next 5 or 10 years. But at today's volumes, this is reflective of all these deals were over 100,000 in incremental units. So that will be spread across North America, Europe, India and Brazil. And we expect those various cooperations to phase in over the next -- the middle of this decade and beyond through the next 10 years. So pricing and profitability, we think, will be in line with profits that we make in these regions. And we kind of view these deals more as return on invested capital opportunities to expand our business and leverage -- leveraging these investments over a significantly greater volume amount. In general, from a first-fit standpoint, we would be making all of these investments anyways, both on the capital and the R&D side to bring our products to the next emission cycles and -- especially as we consider the plant within a plant concept that we're working on with Daimler in Europe, we've got enough capacity to take on these opportunities. And so really, it just results in us leveraging these investments that were just that much broader of the scale. From an aftermarket standpoint, it does offer us a significant ability to continue to grow our installed base. The medium-duty engine can see -- it still has a fairly long aftermarket tail, greater than 100% of the whole [ good ] price in terms of the aftermarket revenues generated over the life of the product. And so it represents a really compelling avenue of revenue for that business, and we expect to see a nice part of stream over the next 5, 10 years as the installed base continues to grow.

You talked about the scale from having to do these investments anyways on the medium-duty side. On the heavy-duty side, it seems like it would be natural that would be the next step.

Yes. We're having a lot of discussions really across the board with OEMs on how we can collaborate in that space. I think the economic equation for OEMs is quite clear in the medium-duty space, given our scale advantage is even more pronounced in medium-duty. And in heavy-duty, we still have a significant scale, but it's not quite as disparate, if you will, between ourselves and the OEMs as it is in medium-duty. So I do think you'll see potential for announcements in the heavy-duty space. I think it's likely that that will come in sort of these sub displacement levels. We tend to think about the heavy-duty market and sort of 3 product niches. You've got kind of the 10-, 11-liter range. You've got the 12-, 13-liter range, and then the 15-, 16-liter range. And so I would expect rather than a widespread heavy-duty announcement perhaps you'll see some collaboration in some of these either that lower end to the kind of 10-, 11-liter where we feel like we have a compelling product today and some other compelling products coming to market as well as in the 15-liter range where we've got a bit more pronounced scale advantage. The 12-, 13-liter range has long been the strength of the OEMs product portfolios. And so that probably would be the last displacement range to -- for them to think about outsourcing. But we're having a lot of discussions with OEMs really across the board, both on medium-duty opportunities as well as heavy-duty opportunities. And then we actually think that there's some good potential in off-highway segment as well despite the fact that there aren't kind of the same emissions catalyst, if you will, for them to consider. There's still a lot of investment needs for OEMs really across the board, and we feel like given our position in the market we can represent a nice win-win partnership opportunities for them.

Maybe moving on to the filtration announcement of the EMEA last quarter to undergo a strategic review. Can you talk a little bit about what catalyzed that decision? And is it as simple as these products are just overtly tied to diesel products? What's kind of the logic of a spin versus a sale?

Yes. So we continuously evaluate strategic alternatives across the breadth of our portfolio and tend to look at businesses on a few different axes, one of which is financial attractiveness and one of which is strategic attractiveness. And what led us to consider filtration for a -- for separation is really that we feel like both Cummins and filtration are well positioned for growth in the short and medium term. In the long term, Cummins is obviously investing heavily on the products of the future. And as we move down the path of zero emissions, filtration, respectively, needs to make investments to diversify their business as well. And so we felt like it was time to separate the business and allow each to invest in technologies and diversification plays that suit their respective needs. We have done a little bit of diversification in the filtration business [indiscernible] last year we got into the mask making business largely for our own employee base. But that's just one example of how filtration can leverage its current products into new end markets, which would be in their best interest, but perhaps not of the strategic interest for the parent. You couple that with the fact that filtration assets generally trade at a premium to where Cummins is trading and it creates a nice value creation opportunity for our shareholders that we wanted to make available to them. Filtration, like many of our assets, has a fairly low tax basis. And so we're open to all strategic alternatives. But the valuation from a sale would have to be pretty significant to offset the tax leakage that we may experience in that scenario. And so that's why we've kind of been marching down the path of a public market separation, whether that's an IPO split or spin because we want to make sure we do as tax efficient of a transaction as possible.

Do you have a sense of time line for the transaction?

Yes. If we're going the path of public market separation, then generally speaking that can take a roughly 12 months from announcement to execution. Obviously, we need to do an audit of the business among other separation activities. And so I would kind of guide people to sometime in Q2 of 2022. But we'll continue to keep everyone updated as we move through the next subsequent quarters and also during our Analyst Day in February.

If we could talk a little bit about some of your nat gas portfolio and some of these more transitional solutions, I think we had some announcements earlier this year from Amazon ordering nat gas units from the [indiscernible]. But can you help us think about what role nat gas plays in the path to net-zero, which you're obviously working towards? And is this also just an ROIC play in the interim?

Yes. I think it's important from our perspective to remember that the path to decarbonization is a cumulative pack, not just a light switch event. And so there's a lot of benefits in our view to some of these bridge technologies, if you want to call them that, from a decarbonization standpoint, which may be more readily adoptable by end users than moving straight to a zero-emissions vehicle today. So we feel like natural gas, also hydrogen and internal combustion engines, in addition to other sort of alternative fuel basis, can offer a compelling solution in the interim for end users. And it's -- certainly it's a little bit more expensive than a diesel powertrain today, especially when coupled with some of the fuel systems, but still a fair bit cheaper than and more economical than a zero-emissions vehicle today. And so we feel like there's a compelling opportunity that these solutions can bring to market. They require less integration of the vehicle and chassis. And so we feel like they could play an important role in decarbonization and can drive a lot of benefit in the near term. We also feel like we're well positioned to capitalize on that given the investments have already been made in these product architectures and so we can essentially deploy them today. We've had a lot of interest on the back of some of our announcements around hydrogen and internal combustion engine. We have a market leading position in natural gas as well. And we think that those platforms can play a meaningful role in the future.

Maybe moving on to some of your zero-emissions technologies. Obviously, you had your Hydrogen Day last year, but can you just share with us your updated thoughts on how different categories will transition to zero emissions over time between heavy-duty, medium-duty and vocational and where you think some of the earliest adoption could come on both the electric and hydrogen side?

Yes, we continue to think that the transition to zero-emissions products will take some time and vary by end market. It's one of the reasons why we've tried to build out a broad portfolio to be able to have a product that meets our customers no matter what their needs are. We do think that zero emissions is the endgame really across all of these solutions. And so we continue to invest in the long term in our new power business. We continue to advance our diesel portfolio. And as we just mentioned, we continue to invest heavily in some of our bridge technologies, if that's the term that folks want to use. In terms of where we see the most adoption, Europe and China still feel like our -- have the most focused [ investment ] today from a zero emissions standpoint, although the U.S. is certainly, I would say, embarking on catching up under the current administration, which we're working with closely and monitoring all the different potential emissions regulations that are to come in addition to the infrastructure build and some of the other build-out of infrastructure that will occur. By application, bus and some of the lower end of medium-duty continue to be where we see most adoption of battery electric. We continue to deploy units in the field in the transit bus space with GILLIG and school bus space with Uber. We've got some new programs coming online with Kalmar for some port tractors and yard spotters. We just did a [indiscernible] for pickup and delivery applications in the medium-duty truck segment. So we -- and we continue to think that applications where the vehicle departs from and returns to the same port at night from a charging perspective lend themselves to battery electric. And that some of our longer duty applications, heavy duty, for example, where energy density challenges and long recharging times create some challenges with battery electric, we think that hydrogen is the right solution there. And so we continue to invest not only in hydrogen in internal combustion engines but also in fuel cells and then continue to see expanded interest in our electrolyzer business as the need for green hydrogen around the world only increases. So it's been, I would say, a constant development. Even since Hydrogen Day less than a year ago, we continue to update everybody on the advancements we make in the business. I think it's an exciting time. We've formed a number of exciting partnerships over the last few months that we think will continue to help us build out our commercial traction and build our revenue base.

I think in a former life you sat on the M&A team and worked on the Hydrogenics deal, but can you talk a little bit about some of the disruptors that are -- the smaller disruptors that are out there in the hydrogen space and in electric that are trying to get into the commercial vehicle market? What are some of the challenges that they're facing relative to a brand that is housed within Cummins?

Yes. So I think a couple of things that we have an advantage on. One is our application knowledge. We continue to have significant experience both within our distribution business as well as in our new power and our engine business on how these various applications work, which is something that we can leverage regardless of what technology is being adopted and something that we work closely with our customers on, particularly at the more regional OEM level. We don't always have that capability in-house. That distribution channel also helps us sell and service the units in the field, and we feel like that will continue to be a really important strategic advantage that we can bring to the table, which is really hard to replicate for a new start-up in the field. And then finally, I think some of the staying power, if you will, or long-term benefits that Cummins can provide have helped us as we've navigated some of these new commercial partnerships and equity partnerships. We have got a long proven history of a significant portfolio of joint ventures and other commercial partnerships, which I think give some of these larger entities comfort that we'll be a good partner for the long term. We will continue to invest in these spaces and be there for the long term. And there's perhaps greater certainty if you partner with Cummins than some others in the field. And so we're really optimistic about what we've got today from a technology standpoint. We will continue to invest to improve that as we move into next new-generation products. And we feel like our ability to then bring that technology to these partners who in turn can bring market access and volume creates a really compelling win-win to help us continue to build that business.

Maybe on the back of that, if you can talk about the agreement that you have with Iberdrola for the PEM electrolyzer facility in Spain and also about the MoU that you recently signed with Chevron?

Yes. So Iberdrola, that's a commercial partnership where essentially we will be investing. Cummins will be setting up a facility in Spain with about 500 megawatts of capacity and the ability to scale that up to 1-gigawatt. And we'll be doing so in Spain. Iberdrola has significant ambitions to continue to build out the green hydrogen economy. And we felt like it was a really compelling partnership opportunity where we could bring our market-leading technology from a kind of electrolysis standpoint, they can bring not only kind of the benchmark project that we've talked about, which is a 230-megawatt potential project with Fertiberia would be the end user, making green ammonia for fertilizer production, but also a number of others in the pipeline where, again, we can capitalize on each other's strengths. With Chevron, that's a partnership where essentially we're -- as part of our broader strategy to promote the availability of hydrogen and hydrogen capabilities to fuel the energy transition. So we see opportunities for hydrogen to decarbonize industrial processes, switching from gray hydrogen to green hydrogen and to fuel both internal combustion engines and fuel cells, as we mentioned earlier. And so we're really just kind of exploring ways to assist in the infrastructure build-out and increased availability and felt like Chevron will be a great partner to work with, not only for hydrogen, but also, as we mentioned earlier for other fuels such as natural gas and whatnot. So we're excited about both of those partnerships in addition to Sinopec in China and feel like we're well positioned to hit some of our targets that we've set out in Hydrogen Day and potentially the next season.

And you kind of answered my question about in light of your $400 million target it seems like you can more than get there based on some of these [indiscernible]. So how should we be thinking about when you could potentially update those targets? And I think also in the last iteration you didn't really have a ton of fuel cell upside in there. [indiscernible] changing that view at all?

Yes. So I think when we set that target, it's with these types of partnerships in mind, although not the specific ones. And so I would say we're pleased with the speed at which we were able to establish some of these partnerships. And we feel like they've positioned us, as we mentioned, quite well to hit our $400 million target from an electrolyzer standpoint. We continue to be well positioned to hit our rail commitment with our partner, Alstom. And then I would say we've been pleasantly surprised with the amount of interest on the fuel cell side outside of the rail segment. Their products and ourselves signed up an MoU to provide their fleet with fuel cell powertrains. And so we continue to expect to see a significant amount of interest in fuel cell technology. It does still feel like that's perhaps a little bit further out. And so we'll continue to assess targets that we can share with you all. And I would say the next kind of iteration of when we'll revisit those commitments will be in February at our upcoming Analyst Day.

Great. Well, that just brings us to time. Jack and Matt, thank you guys so much for the time this afternoon. Thank you to everyone who's listening on the webcast. I hope everyone enjoys the rest of the conference.