Cummins Inc. (CMI) Earnings Call Transcript & Summary

All right. Great. Good afternoon, everyone. My name is Dillon Cumming. I'm the machinery and construction analyst here at Morgan Stanley, and with me we have Cummins Incorporation. So from the company, we have Chris Clulow, Head of IR. So Chris, thanks for being with us today.

Yes. Thanks for having me, Dillon.

Yes. So I'm just going to read one quick disclaimer. For important disclosures, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative.

So with that, Chris, I want to jump into Meritor first just given that it's sort of topical in the market. You guys just closed on that in early August. Can you just provide a little bit of an update in terms of the early integration of that company and how things have kind of gone since the closing?

Yes. It's gone well. I think we got into the integration. We had busy 3 days. We had a change in CEO, earnings release in Meritor closing in 3 days. So that was fun. So -- but it's going really well. I think we're digging in now looking for the key integration points; welcoming, of course, the employees; and looking for how does it fit in the business. What we can see already is the culture matches very well. We see the same opportunities we did when we were doing due diligence. And we know Meritor for years. So I think we're continuing to leverage that, breaking it between -- it's going to be in our Components division for their core business, their traditional business. And then the eAxle moving into their -- our New Power business. So it's a great opportunity on both sides, and we're really excited for it. I think we put out as guidance. We'll continue to drive synergies. We expect about $130 million by the end of the third year, and we'll continue to investigate that if we have updates to that. We're feeling confident in that number.

Yes, absolutely. I think in terms of the industrial logic of the transaction, right, you had mentioned that kind of acquiring the company gave you the seat at the table with regards to kind of every eAxle electrified powertrain negotiation, right, being able to buy kind of a fully integrated system, which you guys just put out in the press release this morning, thankfully. I guess since the closing of the transaction since you put out that release and kind of come up with that solution for customers, are you seeing an uptick in customer interest already?

Yes, it's been really nice because the eAxle is -- it's a great entry point for the conversations. You're building the vehicles from the axle up, and it really elevates that. The other point is Meritor is a great company. We've been in the business a long time, but we provide a better access point. So it's -- our CEO is talking to their CEOs versus in the past that might have been Meritor's CEO talking to purchasing and it kind of the development, and we can just elevate the conversation and now providing a full suite of products. It's really helped us quite a bit.

Yes, absolutely. And I think honestly, over the last cycle, M&A, you've obviously taken a much more aggressive posture doing a deal like Meritor, Hydrogenics and a host of other smaller transactions. I guess the natural next question is, what's next, right? What are you looking for in terms of products, geographies, ZEV architectures. What's the next kind of area of focus of the company?

Sure. Yes, we're still looking and we're still in the market. We -- as everybody knows, we have a fairly conservative balance sheet approach. So we're digesting Meritor now, but we're open to what else is in the market. And it could be something in our core business, kind of like the Jacobs acquisition we just did, which is a good price, continuity of supply and good technology, all in one. It's like we had the 3 legs of the stool. If we see something like that, those won't be massive ones like probably Meritor, but there'll be smaller acquisitions, we'll take advantage of that. The other side is New Power. That's the future of the company, that's where we're headed, and we expect to make further acquisitions there. We do have a full portfolio, but there can be new technologies that emerge. Right now, we're taking the approach of making a lot of small bets as many are and really looking at technologies, but there could be things that we pick up. And the other element I see in the kind of the New Power segment, which is battery electric and hydrogen as well as electrolyzers is there's a lot of players in the field now. And I think it's almost inevitable that you'll get some consolidation over time, and that could free up some good assets. Those that haven't quite made it to commercialization or even capital, it could be an acquisition opportunity there, too.

Yes, absolutely. I then want to spend a lot of time on the kind of ZEV dynamics in front of the company because you mentioned it is the future, right? And I guess starting with hydrogen, right, you're most kind of commercially mature product portfolio that is open today is the -- into the electrolyzer side of the business.

That's right.

Longer term -- obviously, you've been doing a good job ramping it from a sales perspective. But longer term, are you kind of concerned about the commoditization of the technology, right? There are a lot of players in that market? How are you thinking about that longer term?

Yes, we're feeling really good about the long-term prospects of that market. When the growth is just -- it's been exponential. When we acquired Hydrogenics, I don't even know if we envisioned it could grow like this. And then you have additions like the Inflation Reduction Act, just further accelerating hydrogen adoption. And it is -- I think there is a technological edge to it. So it's really in the stacks and how you design it, driving the efficiency for the customers and driving to scale because it used to be -- in the electrolyzer space you would have, a couple of years ago, that 2-megawatt project was a big project. Till now the largest is 20 megawatt and soon to be 25 megawatt, but we're talking to people about 250-megawatt projects or gigawatt projects. And it's just -- with that, you just need, one, the technological efficiency that we can help drive; and two, is dependability and support because these require a lot of support, and you want someone who could back your products, and that's where we're in a great position to do that. So that gives us, I think, a big edge as well as the added thing is such our total network covers the globe. So if you want to build one in whatever reach of the world, U.S. regulations permitting, we're there to support it.

Yes. Got you. As you mentioned, the manufacturing side of the business, right? I mean, I think you had originally laid out a 2-gigawatt hour target by middle of the decade. But I think since then, there's been a lot of domestic support both here in the U.S. for incremental hydrogen production capacity and internationally as well. How are you thinking about the time line to your own production capacity both by the end of the year and then in longer term and also that 2 gigawatt target?

Yes, I think that is going to be the big pacing items, who can expand capacity? Who can drive the sourcing and the production capacity to meet this demand? Because the demand is not the issue. Europe. U.S., China, all are rising quickly. And so I think we just actually announced something earlier today. We're going to take our Belgian facility up from 0.5 gigawatt up to 1 gigawatt. We're expanding that among others. And we'll be -- at the end of this year, we'll be at about 250 megawatts. It will be 700 megawatts to 1 gigawatt by the end of next year. And then 2 to 3 gigawatts the year after. And that's outside of the Sinopec investment in China, which will be another half to a full gigawatt.

Got it. Maybe if we can switch over to kind of the fuel cell and electrification side of the overall portfolio for you guys. Where are you with regards to the commercialization efforts there, especially on the fuel cell side?

Yes. I think the fuel cell side is going to take time. It is -- I mean, I think we're doing well. We're in the testing phase. It's the really fledgling technology still. And it's going to take a while to adopt as it gets to where -- because the customers for the fuel cell, which we think will be primarily in the heavy-duty truck as well as the big engine space, whether it's mining or other high horsepower applications. It's all about total cost of ownership and dependability. And I think fuel cell needs some time in development there. We're feeling really good. We have announced several good collaborations with Scania, Daimler North America and Komatsu in the second quarter. So we're working with the customers to develop this, but it's probably -- it doesn't change from our time line we laid out in our Analyst Day where commercialization and big pickup in production is probably in the 2030s -- beyond 2030. In the meantime, we're seeing some good pickup in hydrogen internal combustion. So that's a little -- that's like the baby step for a lot of the OEMs where they feel comfortable with the technology, and they can make a move into the space without taking the full leave of fuel cell.

Yes, I wanted to ask about that, when you just announced the agreement with Werner, I believe a couple of weeks ago, for that hydrogen ICE product. I mean is that a long-term decarbonization solution for your customer base? Or do you feel like it is more of a bridge technology towards fuel cell?

Yes. We think it's more of a bridge because in the long run, you get efficiency gains with the fuel cell. So -- but in the short run, you are able to adopt it at a lower -- much, much lower cost initially. You have a more cost than you have for a diesel internal combustion primarily driven from the tanks and some of the other components, but it is a lower outlay to begin with. You get familiar with it, and we think it will be a pretty long bridge until we get there, and that's getting some good pickup. And you can start -- while the infrastructure, which is a huge pacing item for hydrogen -- transport is developing, that's a good way to get into it.

Yes. And maybe related to that product suite, but also just kind of going back to the comments you mentioned in terms of the overall adoption curves that you laid out at the Analyst Day, right? I guess I've heard some feedback that if you look at the Inflation Reduction Act, right, there's a lot of support for hydrogen, especially with regards to the hydrogen production tax credit, which really does alter that TCO in favor of hydrogen, right? So do you feel like that might accelerate adoption more in the near term may be you kind of laid out at the Analyst Day?

Yes. I think we've done a lot of analysis on the IRA and we fully support it, and it had really everything in it that we wanted. And so we think in the short term, it accelerates hydrogen production, really good for the electrolyzer business. We don't think it dramatically changes the time line on fuel cell adoption, and it's more of a matter of what I indicated. It's like dependability and the cost. Even with the incentives like $3 a kilogram, it doesn't bring it down to equivalent. So there's still ways to go there, both on the initial cost of the fuel cells as well as the fuel cost. So it's -- we don't see a great alteration in what we've presented.

Yes. Maybe wrapping up the discussion then on ZEV, but the other big debate in the market is with regards to the overall rates of parts consumption, right? I think when we've originally seen some data out there back in like 2017, 2018, there was a thought that ZEV architecture has had a lower price consumption opportunity relative to ICE, but it seems like some of your OEM partners have like changed their thinking there a bit more recently. As you look at the long-term opportunity, what do you think is the parts opportunity for ZEV relative to ICE now?

Yes. I think it depends on the applications as well as the technology. We think with battery, it would be the -- it's probably got a little bit lower. It's got a greater outlay in content to begin with, but the parts consumption is lower, but where we see that being applied is actually not where we generate our aftermarket now. So we think that's more in the medium-duty space and below where you have more localized charging and small movements of goods. When you get into the heavy-duty space and the high horsepower space, which drives most of our aftermarket revenue, that will be fuel cell, and we think that will be equal to or greater on the aftermarket side because of just the maintenance required, the service required in that. So we're feeling net-net, it's actually a gain on the aftermarket side.

Yes, makes sense. Maybe shifting the conversation a bit nearer term than in terms of your near-term kind of guidance outlook for 2022. You had obviously left the top line EBITDA margin guidance unchanged last quarter. Just at a high level, first of all, what is -- I guess to what extent is the top line outlook still kind of constrained by overall supply chain pressures?

Yes. Unfortunately, it still is. And I think that -- if I look at our on-highway production in North America, it is very much constrained. It's gotten better on the supply chain side. It's gotten away, I would say, on a macro basis. However, electronics and chips are still unfortunately because I'm sick of saying it. But it's still the pacing item, and it is still really gotten more stable where we're confident in our ability to produce, but it's put a ceiling on both for us and the OEMs for the ramp. So they're not getting much more. So it is capped that out. And then on outside of that heavy-duty and medium-duty space, if you go into the high horsepower, that was lag in the supply chain impact by probably 2 quarters. And so that's more in -- we're in the thick of it now. We're getting through that. The list of parts we're chasing is getting shorter. And so -- but it is still limiting the overall industry production in both first fit as well as aftermarket. We're still -- run below demand.

Yes. So when we think about maybe broadening out the scope of supply chain challenges to include things like premium freight, labor, material costs, right, have you seen those kind of cost dynamics play out over the last quarter or so?

Yes, Yes. So I think we're seeing good movements and positive movements in premium freight. We've done a much better job this year, one, controlling it and just monitoring it as well as passing it on to our customers. Freight rates -- the spot freight rates are coming down they haven't translated through to the contract rates, which we utilize. That will probably -- it takes a lag of a quarter or 2. So we'll see that towards the end of this year for those to start normalizing. Commodities are coming down as well, so that flows through us. And then the one exception that's not coming down as much is labor costs. So labor cost is probably where we're still seeing upward pressure, and we're kind of pushing and dealing with that. We'll continue to do pricing. That really kind of leads to -- we expect to do more pricing in the January environment. We've done quite well this year on the price cost, but we have our ways to go -- get to where the margins we want.

Got you. Maybe broadening the scope to include European energy, electricity cost concerns, right? I mean anything coming from the ton of exposure. But you do have some, I believe. Can you just kind of talk through both the direct impacts in terms of gas availability and electricity cost inflation and then whatever derivative impacts may have you seen at the customer level in terms of their own operations?

Yes, yes. So for us, we're not as directly as exposed. Most of our facilities are in the U.K. or in more Western Europe, in Western France, and we have a couple of facilities in Germany. None are operating currently on Russian gas, which is a big threat. And we do see -- so we don't expect a direct impact, we do expect costs to go up, and that's going to be the hit that we take. It is less than 1% of our cost of goods. So even with some big rises, we don't expect a huge impact to us, but we're -- it's something we're closely monitoring. We also have the luxury of having genset as a backup at all our facilities, which is good and the people to fix them if there is, however, an issue. So we do have that. So we're feeling good about our operations. I think what we're watching really closely is what's the impact both to the customers as well as supply chain. So there -- it's just another, another headache in the supply chain of endless headaches of what could be potentially disrupted there. So we're working with each of the Tier 1s and Tier 2 and 3s that might -- could be impacted. Watching that closely, it's going to be a -- something that's going to be very closely monitored through the winter as things that colder and gas usage or energy usage goes up.

Yes, absolutely. Maybe just putting a bow on the price cost and supply chain discussion. Can you just remind us what your own expectations are for price cost in the back half of the year, maybe in early inklings in '23? And then with regards to pricing in particular, how you'd characterize the overall environment in the context of all the pricing you've taken and your peers have taken really over the past 2 years or so?

Yes, yes. So for the full year, we've -- and I'll get into the second half. But full year, we've had about 400 basis points of price increase, which is the most we've had in quite some time, recent memory, versus about [ $250 million ] of cost increase. So ahead of the curve there, and it's probably about 100 basis points better in the second half on pricing than first half. So we've continued to put some more pricing in aftermarket; in our Power Systems space, which lags a little bit. That's all kind of in there and already kind of built into our guidance. And then as we go towards the beginning of next year, the environment is still pretty -- I would say much more open on pricing. So it has been a tighter environment as we look back historically, but we expect to put another -- not quite as significant, but another fairly significant price increase. Some segments will be more than others. We expect the price more in the Power Systems segment, where we have that pricing lag. It kind of ran behind us and impacted our margins. So we'll push more on the Power Systems side, but we'll have them and really across the board, we'll have more price increase. And we've had the conversations -- we're having the conversations now with the OEMs. We also see the prices there, actually indicating that they're going up. So there is room there. It's an easier conversation than normal, but I think this is another good round of pricing will be upcoming.

Yes. Got you. Maybe we can kind of zoom out for a second, thinking about North American truck cycle, right? Still the topic of discussion is part of the ZEV commentary. But look, I think [ ACT ] has been taking down the '23 build-up and is pretty significantly in recent months, right? I think it's about 25% lower than it was at the start of the year. Maybe some debate about whether or not they've gone too far in the that direction, but I just wanted to run that by you. What your thoughts were in the cycle into next year and how resilient or not resilient things could be kind of in '23?

Sure. Yes. It is really interesting conundrum because I think this is the first time I've had [ ACT ] being the most pessimistic. They're usually right in the middle and then find a way always right in the middle. So it is -- as we talk through with the OEMs, we actually -- it feels a little tone deaf. You know what's going on in the economies around the world, but the indicators within our market and industrial overall are still quite strong. We since checked that we brought ahead our own investor conference to speak with some OEMs, some end users, some fleet owners and brought in a large group a couple of weeks ago just to see where is everybody else seeing it, making sure we're kind of triangulating on. And everybody unanimously was like this is going to continue. Demand strong. '22 is certainly fine, and '23 is strong as well, like above where [ ACT ] is. And that was unanimously everybody was above it. So it's really the -- we still have a very strong backlog. The order rates in August as they open up, order board is just getting stronger. So it's over 200,000 in heavy-duty truck on backlog. And medium-duty truck, which is usually the one which turns. If you see a downturn, median will turn faster. It's actually kind of an 80,000 truck backlog. It doesn't have a backlog. So you're seeing more attention paid in that. So I think that will play out well through '23 as well. So despite all the economic indicators and impacts on retail, it's still quite strong.

Yes. I think I know the answer to this. But if you look at your parts business, that was kind of the precursor to the last kind of truck down cycle like we saw in 2019. Any signs of deceleration in truck utilization, parts utilization, et cetera?

Yes, not at all. I think it's the parts. We've done really well in the aftermarket, driven by heavy-duty and high horsepower this year as we're up about 15% to 20% and really strong performance. We're seeing the same thing, not an increase. But as we go towards next year, continued strength. And it's -- the demand is high, like I said, even in high horsepower, which gets a lot of parts impact in the Power Systems business. We're not meeting quite the demand because mining rebuild, oil and gas rebuild is -- the demand is far higher than we can deliver. So we'll keep -- I think that will keep brewing it, and heavy duty will keep it strong. Even if you see an inflection point and used truck prices going down, the population out there continues to increase that keeps us strong for '23.

Absolutely. Maybe moving on to some more growth opportunities for the company as well, outside of the ZEV universe. Over the last couple of years, you've done some new platform wins of Hino Isuzu, Daimler, right, on the medium duty side. What is -- again, what's next, right? I mean what competition do you have in your other OEMs? I guess how near term of those conversations and not only on the medium-duty side, but also on the heavy-duty side as well.

Yes. So in the medium-duty side, there's probably not much more to go, I mean in North America. So I think the Daimler, Hino and Isuzu wins brings us up to really the vast majority of share in North America. That will increase as Daimler will exit by the end of '24 in medium duty. And we'll have all of that business, I think, other than Ford. And then -- but that will have more expansion in medium duty through the Daimler. But in the middle of the decade, we take over the Europe piece, Southeast Asia and South America. So that adds -- those 3 combined is about 100,000 units. So more to gain in the medium-duty side. And then the multibillion-dollar question actually is heavy-duty share. Where does that go? And I think we're working with the OEMs now and certainly partnering with them, what's the direction they have. They face a really difficult decision because they have so many things they need to invest in. And that's why they shifted in medium duty is they have autonomous. They have the New Power segment, the trucks themselves and all of those things, and it's a lot of pressure. So it's when do they make the move to outsource to us right, is kind of the question. We're having good discussions with them. It's difficult that -- there are emotional discussions almost with many of these. This is the heart of their companies for first almost like century in some cases. So it's -- we want to partner with them well. We see some opportunity in the heavy-duty side. In the short term, even if people don't move to us, we do see some growth opportunity in share just through natural gas. As being the only natural gas engine provider, we're bringing a 15-liter natural gas engine in 2024. And from an emissions perspective and an ESG perspective, it's a really good step for the many that are interested in. We're getting a really good uptake. We had a really interesting press release of several weeks ago. It was between Chevron, Walmart and us. And it was -- people were like, where is the OEM in that? So but it is -- just shows the customer pull that they really want to use this engine. It's a really good step for them. And as we gain that, that will just drive a little bit more share as emissions continue to increase.

Yes. I mean -- do you have a sense of what signpost these OEMs are looking for in order to shift that heavy-duty share to you? Because you mentioned it's part of their fabric and I get the parts opportunity associated with it. But to your point, a lot of them are prioritizing their own hydrogen fuel cell electric investments. So what is the next kind of catalyst they are looking forward to shift that over to you?

Yes. I think there's a few things. California moving in 2024 will give some indication, but it's when the regulations for 2027 get finalized and people can see what they are. I think that will drive some consideration because that's normally when people make a decision to switch, is, do we make the investment to get to that emissions level or do we outsource? So that's, I think, a big piece, and it's just -- once we get some momentum, I think it will increase. And they're also looking at how is medium duty going. Are we meeting our support for them? And are they happy with that? And they are. So I think that is another proof point for them. But that -- I think the emissions is going to be the real driver.

Yes. Got you. Just latest thinking around the filtration separation. It's obviously been a point for you as well. But what is the kind of time line for that in the context of bringing Meritor into that side as well?

Yes. So we -- I think with the filtration side, it's a really good piece of the business. We're continuing along the strategy of separation through a public offering. It's somewhat market-dependent as you might imagine. So the market is not all that friendly for that separation. It's going to be a 2-step process where we'll still own the majority until we fully separate it. But it's -- we're watching the market closely and see when is the right time but committed to the strategy.

Yes. Got you. We have about 5 minutes left. I want to open it up to the audience, see if there are any questions first.

Two questions. One on the transition where you talked about the tough decision for OEMs to shift to outsource to you. Do you see that mostly happening as -- in the context of the shift to hydrogen? Or is that happening regardless?

Yes. It's kind of happening regardless because it's kind of the economies of scale, and we continue to gain more on scale, which gives us a cost advantage. And when our price becomes better than their cost, it's really kind of -- their investors are going to push. So I think it's part of the energy transition to hydrogen, what it's -- we announced earlier this year, we had this fuel-agnostic engine, which just added more to our scale. It's the same bottom end of the engine, different top end depending on fuel. Could be diesel, natural gas, hydrogen, gasoline, propane. So those economies, we leverage our scale and keep building more and it fits well in the truck. So it's just -- it starts continuing to play from a cost-benefit perspective. It's just playing out that way.

Now you talked about the -- the hydrogen internal combustion being a nice, quiet "baby step "towards that ultimate. But it seems like the way you're looking at it, everything I heard you talk about today, you see hydrogen as the inevitable outcome where we're going with heavy truck. Just listened to Fisker earlier today, and he couldn't have been more contrary in his view. Now speaking of passenger cars, but saying basically the GM and Volkswagen's commitment to battery electric vehicles means that, that is the future. It's not Tesla that made the terminations. It's when you see the commitment, and he thinks that the charging infrastructure that's being developed for that. My question is are -- there's 2 completely different worlds. Now are we going to see that because one is for commercial trucks and one is for passenger vehicles? Or do you see a scenario where maybe down the road, after you've developed the infrastructure with more buffets -- truck stations in his hydrogen, but everything you need to do for the infrastructure for hydrogen, does that then become available to passenger cars? And his prediction that battery electric vehicles for cars is inevitable becomes false? I'm really asking you, what do you see the future playing out for both sides?

With hydrogen coming down. I think we're looking at it in terms of battery coming up. That's just a really difficult proposition. Just pure physics with the batteries right now, where you're not having -- if you have a heavy-duty truck, it will just be hauling a battery. In terms of moving downward in the fuel cell, that's got potential. And I think I was reading a few articles on that now. We think medium-duty right now will be battery is probably the primary, at least early on in adoption, but that can start moving down into even past U.S. As fuel cells become more efficient and drive down, you also don't have lithium as a big deal. And that's the other big piece about -- that will pace the item on commercial -- moving to commercial vehicles is -- automotive is going to suck up so much of its supply. How quickly can commercial vehicles move to battery is in question even without infrastructure.

Even without their infrastructure earlier, hydrogen support battery charging?

I think for commercial vehicles, hydrogen probably has the advantage because you have greater range. I mean you can build out, even what we saw early on in some of the cases where you'd have cities in Europe who are saying no more diesel. It's going to be electric in the city. They didn't build out the infrastructure in the city and what -- it's created a conundrum for them to even enforce their rules in those no-diesel cities is because they don't have the infrastructure. It takes a lot to build that out. Hydrogen, I think, you can build out a little more dispersed for commercial vehicle and have a greater range, and that allows you to build it out with maybe less pop-ups there.

Maybe just to wrap up with a couple of quick questions on China. It's obviously...

I thought I was going to escape.

Really easy softball to end to that, right? Yes. No, look, I think there is still debate about what that market looks like [indiscernible] lockdowns, right, helping things in 2022, but it seems like we're starting to get some rumblings of stimulus into next year. So when you think about both truck and construction into next year, what is the kind of stimulus-driven outlook for that market, if you want to help that?

Yes. It's the most difficult thing to predict right now. And I think it's a few factors. I mean this year has been tough. We knew it was going to be tough. Market was cycling down. We are having a change in emissions and then you have the COVID lockdowns, which has just created ongoing noise and really sap the consumer confidence in China. And so that's really kept the markets down. They're slowly improving. We're seeing some of that. Some stimulus going through now, but it's not having much of an impact. I think as it goes to next year, I think we're watching closely some of the Congress meetings and the elections in October. And what changes there? Is there a change in the zero COVID policy? Is there more stimulus that goes in? And that's going to pace how quickly they rebound. We don't expect a 2020-type rebound where they just skyrocketed after being still, but we do expect some movement in China in a better year next year.

Got you. We're at the top of the time. So Chris, thanks for the time. It was a great discussion, so thanks for coming out.

Appreciate it. Thanks, Dillon. Thanks, all.