Cummins Inc. (CMI) Earnings Call Transcript & Summary

Thank you for joining us this morning, and welcome to Day 2 of the 2021 Baird Industrial Conference. My name is Luke Junk, and I cover vehicle technology and mobility for Baird. We're very pleased to have Cummins with us today, $35 billion market cap. Cummins is the leading manufacturer of engines and related components serving both the on- and off-highway markets. TTM sales for the company are about $23 billion. Joining us today, we have Mark Smith, CFO; and Jack Kienzler from Investor Relations. We do have 30 minutes for this session. So I'll do my best to weave in any questions that you have. You can submit those through your web portal or if you'd like, you can just e-mail me directly as well, [email protected] is the e-mail. With that, I'll turn it over to Mark for some brief introductory comments.

Okay. Great, Luke. Thanks for inviting us. It's great to be at your conference, albeit sadly not in person yet. So hopefully, next year, we're here. I appreciate everybody's time this morning. Yes. We're close to wrapping up an interesting 2021. I think we end this year with a high degree of confidence about demand momentum in most of our markets, China being the exception. And like many others within our industry, battling through our way through supply chain challenges, which have both impacted our industry's ability to supply customers against this backdrop of very strong demand and also impose some significant additional costs on our business, which we're working through as we kind of set ourselves up for 2022 and beyond. But I think the overwhelming theme in our core business is very strong demand. We continue to invest in our new technologies as we approach technology transition in some of our markets. So we'll continue to invest there. And of course, we continue to generate excess capital and return that excess capital to shareholders on a consistent basis. So I think nothing new or exciting to say other than we feel confident about the demand environment right now and working through plans to improve margins, continue to deliver a very healthy cash flow generation, keep positioning the New Power business for future success. That's kind of what's on my agenda most of the days of the week right now.

Okay. Great. Well, yes, thanks for that overview, Mark. Why don't we jump right into the Q&A here. And I want to talk about the current state of the industry and some of the disruptions out there. First, if we could talk about what you're seeing real-time in terms of trip-related impacts on production at your customers? Certainly, this is something that more broadly across heavy vehicles and light vehicles has been a big issue this year, maybe had crept up on us a little bit in the back half of the year in terms of the impact in the commercial vehicle market specifically. Are you seeing any signs of life or any light at the end of the tunnel there or pretty similar dynamic as to what we've seen in the first few months of the second half?

Yes. I would say, generally, the supply chain challenges have broadened in different ways. I know you're asking me about chips. I'll refer to chips, but I think our industry faces much broader challenges than that. We've become extremely concerned about chip availability end of the third quarter, beginning of the fourth quarter. We started to communicate with investors then that, that was a concern. By and large, not totally, but we've certainly avoided widespread shutdowns of operations. Again, very much, there's a lot of variation in the design of, in our case, engine control modules and the exact chip specification. So it's very much a model by model kind of set of challenges that we've had. So it's not that we source one type of chip, and therefore, we face just one problem across all of our production. So it's been a challenging process of working through the industry constraints. Visibility, I think, if you ask, certainly, if you ask us and if you ask many of our peers, visibility or confidence to the rate of improvement has not been that forthcoming. So with widespread shutdowns, I would still say there's more belief in what we receive than what's predicted. And so I think given the lack of inventory in the pipeline, at least in the near term, that remains a concern. I will say on that primarily but not only impacts our engine business. They have improved their ability to manage through some of the challenges. And so some of the excess costs that we saw in the first quarter and the start of the second quarter started to ease a little bit. We're still facing significantly elevated costs associated with expediting material and some other factors now. But the costs have come down somewhat in the engine business. What we're seeing now is the challenges in the supply chain have spread more broadly across multiple electronic components, primarily coming from Asia, Southeast Asia. That's impacted our components business more. And so, in fact, their costs have been escalating as they've had to deal with a raft of changes, throw in the fact that COVID's still here, labor shortages exist in many aspects of the industrial economy. And so it's been an ongoing battle. And I say that not to be morose, just to describe to you that the headlines have all been about chips. It's much more extensive. And then, of course, we're building engines and engine-related components, transmissions, et cetera, our customers, of course, have to deal with their own engine requirements. Sure, there are chips on many other elements of trucks or construction equipment and other challenges that have led to what's been a fairly flattish level of truck build certainly in North America, whereas demand would indicate you should have a significant increase in the build rate though. A lot of us have been struggling, working closely with customers, suppliers, but I would say, for now, those challenges persist. I'm not anticipating widespread shutdowns or any deterioration, but it remains a daily battle. And then you've heard from the industry, certainly in the truck industry in North America, yes, some OEMs have been building, maybe all of them, I don't know for sure, but some of them have said publicly that they've built trucks that they're unable to ship because of some missing part here or there, presumably they've all got engines in them. But clearing up that backlog of, let's say, almost complete trucks is providing a disruption to the kind of ongoing level of industry production in the near term. So that's really what's been going on, and so it remains a challenge. We made some progress in the engine business, broader challenges in components, certainly some issues in other parts of the business.

So yes, a great overview. I want to switch gears a little bit here, stay with the macro, but go into the demand side. So you've referenced a couple of times here that you see the demand backdrop is strong overall. And as we look across the world of on-highway especially, would you say that the freight market is really the most important indicator as to the underlying health of the demand backdrop in your markets right now?

I think there's freight and then part of the supply chain issue is bottlenecks at ports. So all those ships and containers waiting to be unloaded is freight yet to be booked and recorded. So I think for now, yes, I think the demand to move materials and goods is only going to increase. We've got the holiday period coming up, which usually is a period of high movement of goods and freight. So yes, there's kind of a backlog of macro demand. And then on top of that, customers have already placed orders for trucks, right? So we have very robust backlogs, so that's also important. Again, backlogs can come and go. But right now, those backlogs are building. I think in medium-duty truck we're almost at an all-time high. So that's encouraging. And then used truck prices, certainly, particularly in the heavy-duty side, that's an important part of the transaction for the first owner is that resale value. And resale values are high, which means it's usually advantageous to trade up and trade out of that vehicle when you reach that optimum period, whether you're owning it for 3 years or 4 years. That's usually conducive to new truck sales. The missing link in all this equation is full supply. And if we had full supply, then the market size and our revenues and industry revenues would be well in excess of where they are today. So that's I guess that. The upside is the demand to come assuming, touch wood, that the economy remains robust. But I think, even for now, given this pent-up demand and lots of goods to be processed and still working through inventory replenishment, it feels like there's good momentum heading into 2022.

Okay. And so I want to touch on China briefly as well. Clearly, that's a market that has some very specific impacts coming off of the midyear implementation of NS VI. And just wondering if that market being harder to gauge in the near term, what you're hearing real-time on the ground right now in terms of working through prebuy, where inventory levels are of trucks and some of the factors that might signal that we're getting closer to a bottom in sort of the post NS VI phase in China, if you will.

I think lower new orders is the best sign we're getting closer to the bottom right now, unfortunately. Yes, I think it's hard to gauge exactly what the inventory levels are in China. But our, let's say, informal assessment, certain dealers in certain regions, indicates there remains a fairly healthy overhang of NS V products yet to be sold. And so the momentum is not to a surprise to the upside as you will see October data or November data here shortly for the industry, but the momentum isn't strong, which is not surprising. I mean, we've been calling for a fairly precipitous decline in the second half of the year for some time. Unfortunately, that's here. It's not a surprise, but I think it's going to linger for a while. Again, we'll see what activity, what elements of the economy the government is looking to accelerate next year more so than any other market we serve. The influence of the government seems to produce surprises to demand in China more so than other areas. Another factor is, yes, certainly, a portion of the China truck market is related to construction activity because you've got these dump trucks that both go on-highway and then moving materials to and from construction sites. And I think it's reasonable to assume, yes, there's going to be some moderation in construction activity given some of the headlines. Many of the people who are joining us or listening will have read about, yes, debt levels and other factors in home construction. We are not seeing as a precipitous decline yet in the construction activity. But again, as with truck, but for different reasons, we're coming off successive peaks. And so we know that our markets in China are also cyclical, and we're seeing signs of that cooling a little bit but not precipitously at this time.

And just one more question on the macro side. It's really a polling question that we're asking all the companies at the conference this year. And specifically, what we're asking everyone about is labor availability and related solutions. And just wondering, Mark, what's your perspective on the current labor market as it relates to Cummins?

Yes. I think, by and large, the theme is tight labor exacerbated by COVID. And then concerns also about, and I don't mean this in a negative way, there's just concerns about how employees are going to react to if they're not vaccinated, vaccine mandates, how that's going to be implemented, what choices employees are going to have. That's an added concern in our industry. Certainly, we added a risk factor to our disclosures, not because we're keeling over out there, but just to let investors know that remains an element of uncertainty as we go forward. I'll be surprised if that's unique to Cummins, but I can't comment on others. But yes, it's tight. We're having to interview more people per position hired than we can remember for quite some time because I think people in the workforce have a lot of choices today with the strength of the economy. So that's a challenge. I would say, by and large, the biggest challenge we typically face is the ability of our suppliers to ramp up and ramp down. And so it's a multifaceted problem. Clearly, wage rates are rising. We see it in our distribution, in our warehousing networks. I'm not blaming other companies. I'm just saying there are some very prominent players in the movement of goods, and they have contributed to rising demand. And that rising demand has led to rising labor rates. There's no question, whether it's us, our suppliers are paying higher labor rates to try and retain labor. That's definite. That's definitely a factor so far is the way I would describe it. So yes, remains an ongoing concern. It's creating a lot of administration, I would say, but we're not talking production disruptions at this point in time. Again, we know whilst all of our markets don't move in tandem, that's a good thing. We've got to maintain this flexibility as the industry leader. We've got to flex up and we've got to flex down as we move through the cycle. And right now, it feels that need to flex up feels like it's building pretty strongly right now. Yes. We're very focused on policies, procedures, protocols around hiring to give more flexibility to manage this.

Okay. And just a related question just came in from an investor. In terms of any negotiations, is there anything in the near term that investors should be aware of on that front in this tight labor market?

No. I mean, we like to maintain strong relations with all of our employee base. I'm not aware of like some imminent change or similar thing that I think is probably behind that question to the best of my knowledge, yes.

Great. Well, why don't we move...

I mean, there are always some discussions going on somewhere. I don't want to say there's no, but I'm not aware of some impending disruption or something like that.

Okay. Well, I want to move into more of a strategic win for the rest of the conversation this morning. And starting with the engine business, it's now been a couple of years since your CEO characterized the nature of conversations with your OEM customers as more urgent in terms of decisions on new platforms and what their engine sourcing strategies, most importantly, are going to be going forward. And we've really seen that come to fruition this year in terms of your agreement with Daimler, most notably as well as Isuzu and the Hino Trucks announcements. Is there more to come on the medium-duty front? And as you gain more scale in medium duty, is there an element of this that is sort of a self-fulfilling element in that you're able to be more competitive as well?

Yes. I think, for a long time, we believe we have a significant competitive advantage, particularly but not only in the medium-duty space, because for commercial vehicle diesel applications we're the biggest player by several multiples. And I think it's telling, our OEM customers are facing all these competing demands, we're very effective at producing engines but we do have a significant scale advantage. And I think it's important to remember as long as combustion engines exist and play a significant role in our markets, which we believe in several markets is going to be quite a long time. In other markets, new technologies are likely to come quicker. But we're going to have to keep investing. If you want to remain in diesel or natural gas or other technologies, hydrogen combustion, you're going to have to keep investing to advance the technology to meet more stringent regulations going forward. And so it's not just a choice of standing still for the customers who make their own engines. It's a choice they actually have to go and invest more. And of course, every time we're adding more customers to our base, that's increasing, exactly as you say, that's increasing our relative advantage. And I think we've been able to find some clear win-wins where it's both advantageous for us and advantageous to some of the customers that you've referred to, to make this transition. And again, as the CFO, there's nothing more exciting than making more engines than you were already planning to do the engineering work for and the capital investments for. That's pretty high predictability and return on invested capital, cash flow. Yes. We can have debates about how long does the combustion engine market keep growing, but I think what's clear, Luke, is to your question, we're the clear outgrower in this. And since we were making and designing engines for those markets and advancing those technologies, that's good news for our core business. Are there more conversations going on? I'm sure there are several OEMs that are considering their investment plans. So yes, I would say it's not like all the options are done and we're finished here. We think there's still more opportunity. We don't have anything imminent to announce here. But yes, that's still an opportunity. So we keep on with that journey of messaging customers, potential new customers. So that's a big theme, right? We're going to outgrow the combustion engine market, medium-duty truck. Yes, we're going to be the outgrower for the next decade, there's no question about that. And of course, it's not just the engines, then, of course, those engines are all optimized with our own components business. So that gives us an important tailwind as we ride through this period of technology transition that just adds to the cash flow generation of the base business, adds to our overall financial strength, which allows us both to keep investing in the new technologies, I'm sure we'll get to that topic in a moment, whilst returning capital to shareholders. So I understand there's a lot of excitement about pure-plays. But when we sit here and look at the capabilities. We've got global distribution network, ability to support customers wherever they are, we still feel strongly that we've got many assets and capabilities that are going to be important when some of these technologies start to move from, yes, what I'll call, nominal order levels to something of more scale and reliability and performance. And so we're bullish. We will have an Investor Day in February. And we'll add to that message therein, but I think that's the basic case we're making. We're not drawing down other people's extra capital right now. We're generating more than we need in our core business that allows us to invest in the new, leverage the skills we've got. And I'll talk more when you ask me about it. I'm sure you'll ask me about the New Power business, and I'll give you some examples of how we're leveraging our skills and capabilities. But we're in a strong, we're in arguably the strongest financial position in the history of the company. And so yes, we're bullish, right, about these technology changes. We recognize we're not a pure-play but we also don't have the risk of running out of capital, right? Investors get paid as they invest in Cummins. So that's the basic thesis of Cummins right now.

So I'm going to, yes, my next question, we're certainly going to get to the New Power business, but I want to ask about just sort of the between period here between now and an electrified future, there are some pretty significant events coming down the pipeline. We have visibility to carbon emissions regulations coming in 2024, EPA regulations probably a couple of years after that, Euro 7 coming at some point this decade too. And you've got a number of what I would call bridge technologies, if you will, in the portfolio, be that natural gas, hybrid, et cetera. And what I'm wondering is, where are you seeing customer interest pick up right now as folks figure out their road map going forward. And yes, if we could just talk about that a little bit.

I think, generally, when we're talking to the large fleets and customers, the overwhelming message that we hear is economically viable solutions, right? Reliable solutions that allow them to be very productive in what they do. Economically viable has to be part of the conversation for widespread adoption. And so that's part of the challenge for new technologies. New technologies will come down the cost curve and in time achieve viability. But until they do, most of the customers we talk to are not going to adopt in significant scale. I'm talking about the fleets, the end users. It doesn't mean they aren't going to try, aren't going to prepare, aren't going to order some. But economic viability, again, we're talking about truck fleets that are working on quite healthy margins right now, but historically a few cents per mile is the profitability of a trucker, then reliability and economic viability are very important parts of the business model, resale value, which I've talked to earlier. Some of these things have to be proven out by the new technologies. Where we're seeing most momentum right now is a rising enthusiasm for natural gas and certainly in several locations that accessing renewable natural gas leads to a, let's just say, I'll be polite and say an equivalent carbon footprint or lower than the electricity that's sourced in certain parts of the country to provide battery electric power. So knowing that we've got these challenges of infrastructure, natural gas can use some of the existing infrastructure that's already out there. Knowing that waiting for perfection doesn't help with carbon footprint in the interim, we are seeing momentum move towards natural gas. And some of the big freight movers, logistics companies that you're familiar with, they're definitely showing strong signs of interest there. There's a lot of interest in the potential for hydrogen ICE as it's known or hydrogen-fueled combustion engines. That's still in development, but there's a lot of interest there. Again, if there are technologies that we can use that maybe don't meet 100% of everybody's appetite for every new dynamic but can use existing infrastructure and make significant improvements in carbon and then efficiency, there's definitely appetite to hear more about those. And I think, yes, natural gas feels like it's got a momentum. We've had a recent announcement of our joint venture with Rush Industries. So we're seeing a lot of enthusiasm there. Yes. I think we're going to see the story. Our strategy is to provide the technologies that work for the customers when they need them. We're trying not to get hung up on one technology or another. The challenge is, there are quite a few options emerging right now, and so our engineering investment is going up. But again, that's necessary and value-added going forward.

We've got about 3 minutes left here. I want to end the conversation with New Power. And specifically, there have been a number of notable developments in that business this year. What do you see as the most significant developments? And you had made reference to leveraging sort of the core strength of Cummins in this business as well, so if you could speak to that dynamic, too, that would be great.

Yes. There's a lot of momentum, a lot of enthusiasm for green hydrogen production. It's going to be lumpy, right? A lot of this is project-based, but that's our electrolyzer business. So we've established, we've only got a couple of minutes so we'll go quickly, but we've been focused on establishing partnerships. And I think that's a core strength of Cummins. We've demonstrated our ability to develop and nurture and grow partnerships all around the world in significant businesses from starting almost from scratch. So that's a key strength. And we've got partnerships in Europe, got the Iberdrola relationship. We're close to finalizing our joint venture with Sinopec. So we're focused on broadening our channel in the industrial economy beyond some of our typical core markets, a lot of enthusiasm there, a lot of government capital being placed to encourage the production of green hydrogen. But it isn't an overnight thing. There is a certain element of planning, replanning infrastructure that goes into that. So it's not a straight line from here to there. But certainly, the enthusiasm is very high on producing green hydrogen. I think on the battery electric side, we continue with our internal development technology advancement. Of course, we've got a strong distribution network that can support our new technologies there. And then we continue to advance fuel cells, which still have some development work to go to be widely available today. So yes, you will see, we're upping our investments in these areas, not decreasing them. And yes, working hard on establishing those partnerships that give us access to broader segments of the economy.

Good. Well, we'll leave it there. I'm sure we'll hear a lot more about this at your upcoming Investor Day in February. So we'll look forward to that. And unfortunately, well, that's all the time we have for the presentation. Mark will be available for the breakout session immediately following this. So if you'd like to discuss Cummins more, please join us. Thank you to everyone for your time. Mark, thank you for your time as well. The next set of presentations does begin in 9:05 Eastern this morning. And that includes Lockheed Martin, WESCO, Donaldson, Quanta Services, CTS Corp, Fortune Brands Home & Security and finally, nVent Electric. So thank you, everyone, for joining us and hope you have a great day to the conference.

Thanks, Luke.