Cummins Inc. (CMI) Earnings Call Transcript & Summary

Thanks for coming. Today, we have Chris Clulow, who is VP of Investor Relations. Prior to that, he served as Corporate Controller at Cummins, and he's been with the company since 2004. For anyone that doesn't know me, I'm Nicole DeBlase. I'm Deutsche Bank's multi-industry electrical equipment and machinery analyst. We're going to run this session as a fireside chat today. So for anyone in the room, feel free to raise a hand, get my attention, and you can ask your question. For anyone who's listening on the webcast, I'm happy to take questions via e-mail. So just shoot me an e-mail, and I will ask your question on your behalf. So I think before we get it kicked off, Chris has a fun video to share with us today. So Chris, take it away.

Great. Thanks, Nicole, and thanks for having me here today. I really appreciate it, and the virtual setting has worked out quite well. So thanks. What I wanted to do is just kick it off with a video. I was going to talk through the strategy, but better to have our CEO, Jen Rumsey, and our current Executive Chairman, Tom Linebarger, take you through. So we'll play the video and then just jump into questions. [Presentation]

Okay. Well, thanks for giving us some time to play that probably much more eloquently put by them than I. But happy to jump into the questions with you on the call.

Perfect. Thanks, Chris. So I'm going to go through some questions around current trends and what you guys are seeing and then we'll kind of move on business by business from there. So maybe just starting with the very hot topic of supply chain disruptions. Would you say that Cummins is seeing any sort of improvement in component availability? And maybe you could talk in a little bit more detail about where there might be improvement, where things are still challenging.

Yes. I think we continue to make good progress there. It has been over the last 6 months, it seems like it's starting to unlock a little bit where it's not a daily worry. It's in -- and we continue to make progress. It isn't still free-flowing. I will caveat it that way. There's spaces, particularly electronics, still chips and sensors and whatnot there, where there is a ceiling in terms of what we and the industry can produce. But it feels like there's a better floor now where used feel like it was a little more tenuous in terms of -- and we're worried about demand and really having to work it hard on the supply side, just to get there. Demand has always been fine. But on the supply side, it feels like it's firming up some, which allows us to step up production a little bit and continue that progress. In the third quarter, the biggest piece of progress was in Power Systems where it lagged behind the other supply chain headwinds by a couple of quarters because it's just a different supply base, smaller suppliers, more global. And now weathered through that storm and starting to improve some. And we were able to add an engine or 2 on production, which does make a big difference in terms of driving better efficiencies, driving out some of the noise in the process. So we're seeing -- that's probably the place where I'm seeing the most improvement in the last couple of months is in Power Systems. But on the engine business side, I think we're still driving towards that. And electronics is a big piece. We're not the slowest horse in the race constraining the OEMs, but we'd like to produce more for sure.

Okay, clear. And I know your exposure to Europe is definitely below peer group average, but this is a very hot topic with investors, just people digging for any signs of deterioration, especially there. What have you observed in that region recently?

Yes. It's held up better than I think, similar to the investors, it feels like it should cycle down. And when it does, normally, the European cycles are far gentler than we see anywhere else in the world where it's just they tend to absorb those cycles more smoothly. And we are more exposed now with Meritor business as we acquired them in August. They have a bigger piece of the business in Europe. But we're not seeing any sense of the downturn. I think the demand is holding up well on the automotive and the construction side and certainly on the power generation side and some other heavier industries. And I think they're weathering through. One of the things we're watching closely is the supply base. As we're getting into the colder winter months and energy is just one less certain, more in demand, and certainly more expensive is making sure we can secure that. And so we've been working with our suppliers that may be more impacted by some of the gas shortages. Feeling good about keeping their production going, it's going to be a little bit lumpy and maybe a little more inefficient, but they feel they can meet the demand, which is the most important piece for us.

Okay, clear. So moving on to China. This has definitely been kind of surprising to the downside this year. You guys cut your JV income guidance in conjunction with this in 3Q. And I'd say that the commentary from Cummins was a little bit more bearish than it's kind of like become more bearish throughout the year. So I guess my question is, do we at least think about China truck demand has bottomed?

We do. So yes, I will say that we thought that in the second quarter, and they did come down a little bit further. But it is really -- as we look at the split between the demand [Audio Gap] exports, it's at the bottom. It's below 800,000 heavy and medium trucks for 2022. So the worst market we've seen in quite some time, at least a decade. So -- and we're starting to see some signs of slow recovery. It's not going to bounce back. We expect very quickly. We're watching it closely as our everyone for signs of life. I think we did see something just as recent as last week, and they made some changes in how they're implementing the zero-cover policy that's lessening the strict enforcement. And they're coupled that with some relief for the construction market more for the real estate market. So those 2 things came out on the 11th. And we've seen subtle signs like that, that they're starting to drive some things for some improvement in their economy. And those are really key pieces as we try to see the economy recover, and that will help us drive our markets better and particularly trucking.

Okay. And I guess maybe the focus has really been on a heavy and medium-duty trucks in China being weak. What about on the off-highway side of the business? Are there any signs of light in things like, I don't know, mining, et cetera?

Yes. It's been -- I'll start with maybe on the downside. The construction has been weaker. It's been more stable. We knew it was coming down, and it's held at similar levels for excavators. So that's been down -- we called it down 30% and has stuck with that guidance. Strangely, on the big side, the mining, oil, and gas in some parts of power generation have been really strong. Our mining volumes are up over 50%, which we expect for '22 versus '21. Oil and gas is supposed to be up over 75% in China. So the heavy industry is moving and moving well. I think the energy and security certainly drive it. There's been a lot of coal mining as one of the key drivers of the mining industry, but it's -- we're seeing, I guess, a little bit less strength in power generation, but it's held up whether better than the overall market. It's down a bit but single digits versus some other bigger slumps.

Okay. Got it. And then maybe moving to the core market, North America. What are your thoughts on the recent very strong Class 8 orders? Like do you think that's all about the order books opening? Or is there more to that strain?

Yes. We think it's mostly about the order books opening where it came a little later than normal. I will say we were surprised by the level of ordering. We said in August, and we may have talked about it Nicole, if we were looking at the orders for September and October really to give us greater confidence in the second half of 2023. So the backlog we thought would carry through the first half. And we thought if orders were in the $30,000 to $40,000 range in those 2 months that we feel confident in the back half, and then they came in at 93,000 combined. So stronger than we've ever seen them. but I think it is kind of -- a lot of it had to do with the fact that it was maybe 2 -- 3 months' worth of orders taken into. And I think that being said, they would have been strong 3 months, that gave us confidence in the second half. So really, for us, we even saw similar actions from ACT bumping up their guidance as they dropped further down up to the 260 mark. We've seen some other numbers, $260 to $300 million, and that seems like a reasonable range as we go into next year.

Okay. And I guess, taking into consideration that dynamic of order books opening and maybe pushing 3 months of orders into 2, is your expectation based on your customer, but conversations with the OEMs that we're in for a strong end to the year from an order perspective.

Definitely this year. Yes. So I think the orders are very strong, and essentially, we've got the message from not even just the OEMs, but end users like build more. And I think we see order books are very strong. We're building as many as we can. And I think the demand is there for us to max that out in the supply chain. And just hopefully, the cooperates as we go through, and we can get back to the market.

And I think you kind of talked about ACT's forecast for '23. Is your expectation that build rates can kind of continue to increase from here across your customer base?

Yes. I think they'll step up a bit. I don't -- I mean, as where we are in the cycle, a significant step-up in production on heavy-duty, as I say, I wouldn't expect a big jump up because it -- I think it will be kind of more steady through the year. It has been steady, and I think that benefits the industry is kind of a steadier build. So I think there might be -- could be up to a 10% step up, but it's not going to be a huge jump where we're producing over 300,000. That wouldn't be our expectations. I do think we'll see a step up in medium duty. I think that's an area where over the last couple of years, it's been somewhat deprioritized by the OEMs, where they're trying to build the heavy-duty trucks. And that swung back to more of a normal balance, and that drives more production. I think medium duty has some more room to step up. Which just, given the economic environment, seems very strange. Medium duty usually is the one that weakens first, but it's actually stronger given the just prioritization as well as supply chain constraints.

I was going to say that is part of that because the supply chain constraints haven't been as severe on the medium-duty side versus the heavy-duty side.

They've been about the same. I think it's because it's the similar chips and electronics and things going -- it's just we've been pushing more towards building heavy-duty trucks over the last 18 months. And now it's -- we need to meet the needs of the medium-duty customers, particularly the rental companies, the graduate pens are very much looking for more new equipment. And I think that their fleets are aging and they need new equipment. And I think we're -- I think that demand will stick for a while.

And remind me, is Cummins kind of agnostic from a profitability perspective between heavy-duty and medium-duty engines, I don't recall.

It's -- on the first sale, it's pretty agnostic. I mean, I do think heavy-duty drives more aftermarket in the long run. So medium duty just consumes a little bit more parts just based on the duty cycles. But I think initially about the same.

Okay, clear. And there's been this kind of growing view among more bullish industry participants, but maybe the truck cycle, like looking over a longer period of time will be shallower in nature where you get less peaks and valleys, less aggressive peaks and valleys because of the emission standard change really exacerbating the issue before. Where do you stand on that debate?

I'd hope that to be true because it does advantage the industry. I think there is. However, just some nature from an economic perspective, it tends to go with the cycles. We do expect this one because of just the drawn-at nature, maybe more widespread weakness outside of our markets as we go into '23 that might be a shallower cycle and that we would have a bounce back. In terms of ironing out completely, probably not our view, but I would hope it gets a little bit gentle or maybe going towards more what the European norm is, where it's gentile down versus a little bit more erratic.

Okay, clear. I'm going to ask a numbers question on 4Q because I've had this question from a few investors. If you need to take this offline, it's a lot of math, and it makes my head hurt. But -- so you guys have guided without Meritor, but then most analysts have started to put Meritor into their numbers. And I guess where the confusion comes is I've had several investors ask, what's embedded in EBITDA margins or dollars, however you want to put it, ex Meritor for the fourth quarter because you guys have reported, there's all the one-time items that have come in and out of EBITDA throughout the year. So it's confusion on like what the year-to-date number is, I guess.

Absolutely. I completely understand, and it's been like a calculus class over the last couple of weeks. So we had lots of moving pieces here. I'd say without Meritor, the Q4 guidance is 15.5% EBITDA -- and if you normalize the third quarter, we came in at 14%, which was a disappointment to us as well as the market, as you know. So we do expect to bounce back at 15.5% for the core business without Meritor. And then Meritor, the guidance was 4.5% for the year when we owned it, which equates to about 9% for the fourth quarter.

Okay. That's super helpful. And that bridge between 14% in 3Q and 15.5% in 4Q, I know the bonus payment is part of that. Anything else to highlight?

Yes. So there was a few one-offs that we don't expect to recur. Certainly, the bonus payment was a one-off. We haven't done that historically, and it was -- I'm glad we did it. I think it was the right move, but I think we don't expect -- we won't have that recurring -- and then we had some operational inefficiencies, which totaled about $45 million, which were -- one of our plants was just had some operating difficulties late supplier deliveries, some attrition and some other factors that played into just higher costs, about $22 million hit our engine business. And then we had a read-off of some older inventory in distribution, which was $18 million. So in total, with some other small ones was about $45 million of manufacturing inefficiencies we don't expect to recur. So that's about $100 million. We do expect a slight improvement in JV income. We think it bottomed out, and we have some tech fees that come in in the fourth quarter a small amount. So between that and pricing, that's how you -- those are the 2 main pieces and some other small ones to get you up to that 15.5 million.

Okay. Perfect. Thank you for walking through that. Okay. So maybe just shifting to some more medium-term discussion first. Any questions in the room? Okay. So on the engine business, you've gained share on a few internal combustion programs over the past year plus kind of gaining content where it didn't even exist before. So what's your view on -- is there more content out there on ICE business for Cummins to win?

Yes. In terms of overall share, just content on the engine, I just want to make sure I'm answering your question correct.

I think gaining like you have recently gaining engine share with customers that you weren't producing engines for before?

Sure. No, I think there is some space. In the medium-duty space, we gained it with Daimler Rhino and Isuzu last year, and that continues to build in the medium-duty space through 2024, at which point we'll be pretty much maxed out in medium-duty North America. Middle of the decade, '25, '26 time frame, we get the Daimler business globally, which is Europe, Southeast Asia, and South America. So that helps us on the share perspective. Shifting to the heavy-duty side, nothing significant. We continue to have conversations with the OEMs, nothing to announce imminently or anything like that. But I think we are making progress on potentially gaining some share there. Even with the OEMs continuing to produce, as an example, their own 13-liter engines in diesel, we expect natural gas to play a bigger role as we go through these emission cycles 24 per car, $27 per EPA. And we're bringing a 15-liter natural gas over from China in 2024, and the demand is really high for that, I think. And this is -- we've been waiting for natural gas to be a bigger piece for a while, at least a decade. And I think this is the time, given the emissions constraints, where it will drive further natural gas. And by its nature, drive share to us because we're the only natural gas engine producer. So a few factors like that going in. And as we get further down the investment cycle, I think it will continue to put pressure on maybe some of the OEMs, and we can help them meet some of their diesel and natural gas needs.

Okay. Got it. And you still see a big potential for natural gas despite higher natural gas prices. That hasn't impacted demand?

It hasn't. One from an emissions perspective. It can run cleaner. And 2, total cost of ownership is pretty comparable with diesel. The investment in natural gas is more on tanks, but that's about the only differential from an initial outlay.

Okay. Understood. Margins in the engine business. I know this is an area where you're disproportionately impacted by price cost. So with reset of contracts kind of happening around this time frame, is the expectation that price cost can flip to a positive from a margin perspective in 2023?

Yes, it is. And I think it's what -- I contrast that with 2021, where we -- our costs were rising and we weren't able to price, the flip happens as cost drop. So we tend to hold on price a little bit longer, and we have better incremental margins, and that will help our engine business. We will price again in January. And then, with costs like freight, we're already seeing the spot rates come down, hasn't really flowed through to the contract rates to a large security. Same with commodities, those costs start coming out, and we tend to hold the price for a little bit longer period. It reverts to norm overtime over the course of a few quarters, but we'd expect better incremental margins for engine business early next year.

Makes sense. And just remind me, in '22, is the price cost a headwind for engine margins?

For engine, it's -- we're a little bit ahead price versus call -- so I think overall, for the company, where it was 400 basis points price versus 230 basis points cost. So well ahead for the overall company and engine business was ahead as well.

Okay. Understood. Let's see. Distribution. So just curious, would you say that this business, like focused on parts sales, has that also been negatively impacted by component availability at all?

It has. I think we've seen some good recovery this year where aftermarket parts -- aftermarket demand, we've been able to meet more and more of it. So -- but it is still a constraint. So there is more demand than we can supply in both the heavy-duty space on the parts side as well as the power system space. So as an example, mining rebuilds or oil and gas rebuilds, which they do 3 or 4 times during the life of those engines, are -- the demand is higher than our ability to meet currently. So that's part. So we expect to persist where we can continue to do that and service those engines going forward. So the aftermarket is holding well. It's improved through the year for distribution and helped their results, and we expect the aftermarket to hold strong as we go into next year.

Okay. Understood. And distribution has been a segment where you've been focused on margin expansion for some time now, and there's been a lot of initiatives driving that. I guess we're going to be probably 10% plus this year, according to guidance. So how do you think about like the medium-term trajectory for this business? And how much more opportunity there is for margin improvement?

Yes. I think it's a really good question. I think it continue -- can continue to get better because some of the transformation initiatives we did in our North American distribution we can take globally. -- there's less of an ability to price in our distribution business because most of it is pass-through pricing from other segments. So pricing is less of a long lever. I mean, there is some lever there, but not as long. And I think it is -- so we'll do some pricing, there is some room for continued improvement as we drive more cost out and just get more efficient operations. So we're seeing -- we're on a good run. Continuing to increase the power systems' aftermarket support will help that from a margin perspective as well.

Okay, clear. Component. I think the big story here has been the emission standard changes in China and India. I guess just maybe refresh our minds on where we are with the impact to components this year? And what is the expectation for what 2023 might look like in both of those countries?

Yes. So it has definitely helped as we move to BS-VI in India and in China for us to gain content. So you add in after treatment to a moated degree, more sophisticated turbos, fuel systems, that type of thing. So that is -- we've seen that upside. We're seeing that grow in terms of content per vehicle. Of course, the China market being at its lowest point has not helped on that. So it's more than -- well, more than offset the content growth for components. But we do see some continued momentum as we go into next year. As an example, our NSV share is considerably higher than our S5 share was. So we're seeing some good growth in share for the domestic consumption of trucks. It's just the domestic consumption is that are very much a low at this point. So we have to keep building up there. It's gone well in India as well, and we're continuing to grow up on the sales and margin side there.

Okay. Got it. Shifting to Power Systems, finally seeing some signs of recovery in the past few quarters. Can you just give some color on what's really driving that?

Yes. So we were really pleased with that as well. And I said to our Power Systems leader, Jenny, the guy actually just sort of first quarter in running the business, which is a nice one to start with. But it was -- I think we'll get questions on it because I think we just haven't been talking about it because it's been kind of performed but slower and steadier. I think a couple of things really unleashed it, and one was the supply chain loosening a bit, adding a little bit more steady production. We are able to hit pricing on that. So pricing lags in that business, longer lead times. And so we pushed pricing even some on our order board, existing order board, and then future order what it kind of caught up. So pricing was a good tailwind there. And really, it was down to clean execution. They had an incredibly clean quarter, really took the noise out, and just built it. And I think Jenny Bush, who's leading the business, she has taken some of the lessons. She ran our North American distribution as we went through this transformation. She's like, what can I apply in Power Systems? That's not coming through in our Q3 results, but more bodes well for the future in terms of how do we drive for more efficient operations. And can we take some cost out?

That's exactly what I was just going to ask is I assume that there's kind of a longer tail of margin expansion opportunity in Power Systems from here, right?

There is, yes. So I think it's got a performing... We've had asked a few times our Q4 guidance implies a little bit more conservatism on your part, which is true. We didn't want to get ahead of ourselves a bit, but we do expect good things for Power Systems, both in Q4 and then building into next year. It's really kind of turned a corner.

Okay. Got it. We're running short on time here. There's a few more things I want to hit on. So I mean, we've seen comments become a lot more active from an acquisition perspective over the past year or so with Meritor, a pretty big deal from a historical perspective. Is this you guys turning over a new leaf where you're more interested in larger acquisitions? Or is this a Meritor-specific opportunity?

Yes. In terms of the large acquisitions, this was probably fairly specific. That's not to say we won't look at them in the past. I think we were very nonacquisitive would be going in our longer history for many, many years. And I think it's just more opening up to see what the potential is. So I think it will take us some time to digest Meritor, and that's our expectation. But we're not, I would say, out of the market. We're still making acquisitions. Now I think even in the Q4, we have the Siemens acquisition, which, I guess, technically, Meritor made before we acquired them coming in, and a couple of other smaller ones. I think what we'll look at is certainly security of supplies become more of an intense focus as we -- from lessons learned in COVID, some opportunities in the new power space if there's good technology or capacity or things that become available on the market as maybe some of the competitors aren't able to raise the capital. I think those are the types of things we'll be opportunistic about as we look in that. But in terms of big ones, I'd be a little bit surprised if we did something in the short term, I'll say.

Okay. Makes sense. On the topic of new power, we have to talk about this. So I think the general investor perception that I hear is that you guys have done a really good job of explaining how you want to play in hydrogen. But I think there's less understanding about how Cummins would win in a world of more of a shift towards battery electric in some applications. Can you talk about any content that you have on the battery electric side?

Yes. So we do have a full system available on the battery electric side from the batteries, the battery management system, the ex we just acquired from Meritor, and every other bit of componentry really inverters now with the Siemens acquisition. So we have that available. We're offering it in some -- really the commercial application currently is in buses. So we're progressing with Bluebird and Gilead, I think, the 2 primaries that we're going to market with right now. So we feel like we're playing well in terms of migrating into the other parts of the portfolio of the medium-duty trucks, probably the most logical next step. It's going slow. I mean -- and it's not going slow for us, it's just going slow as an industry, which we did somewhat expect. I think battery is -- there's a few hurdles we need to overcome, not the least of which is building out the grid to support all these vehicles. But it is -- I think it's a little bit slow in coming. It feels like overall market-wise. So we're definitely there. We're definitely participating. It's just maybe not as much momentum as we're seeing in hydrogen. I'll just put it that way.

Okay. Understood. And you guys have announced a few pretty big wins on the electrolyzer side already. 2 questions on that. The first is, when should we expect to start to see the revenue come through the newer power business for the electrolyzer projects? And then secondly, can this be over time, a segment that generates margins around the Cummins average?

Yes. So we -- it's still very early in its infancy. I think $50 million to $100 million of revenue this year. So it's really small. Going to what we projected $400 million by 2025, but feel really good about that number, and then $3.5 billion to $4 billion by 2030. So really -- I mean, the good growth rate in the electrolyzer business, and that's not even assuming any adoption by transport, really. So it's just replacing commercial being used in utility gas and so forth. So it has some really good momentum. I think it's going to take some time just to get the lumpiness out because it takes time to fund these projects. And the bidding is, I would say, a little bit rapid. They're out there all the time. The demand continues to be really strong, and they're getting bigger and bigger. So it seems like it's a competition of size now among even states or countries or whatnot, who can build the biggest one. So it's good it actually adds -- it makes more sense from a total efficiency perspective to build bigger. So we're on that path. So I think it's going well. I will say, on a project basis, we're already at gross margin positive. So that is the other costs in the business that take it negative, but that gives us a sense of where we can move towards the Cummins EBITDA percentages. It seems very attainable. When you're at that low demand without scale production without driving a lot of the cost out of the product that still need to happen, I think that we're confident in the margins in the long run.

Okay. Great to hear. All right, Chris. Well, we're about out of time here. So I think we'll go ahead and wrap it up. But thank you so much for joining us today, and thanks for supporting the conference.

All right. I appreciate it. Thanks, Nicole. Take care.

Talk soon. Bye.