Cummins Inc. (CMI) Earnings Call Transcript & Summary

Thanks, everyone, for joining us today. As we kick off, we're going to show a short video just that encapsulates our strategy for Cummins. So we'll kick it off with that and then jump into Q&A. [Presentation]

Thank you, everyone, and thank you for the video. We're very pleased to have Cummins with us today. We have Vice President and Chief Financial Officer, Mark Smith; as well as Chris Clulow, who is the Vice President of Investor Relations.

In terms of format, we will be informal. If anyone has a question, please raise your hand. We'll get a mic to you, and you guys can ask a question. But Mark, I guess I'll kick it off. One of the themes over the past 2 days has been supply chain and it seems like there has been some supply chain improvement. You guys have handled it actually quite well. But can you talk about where there's bottlenecks, where things are improving? And as you approach your guidance for 2023, do we assume things get better? Do we assume things stay at sort of a constant rate?

Good. I'll just start off by saying Destination Zero is not a financial goal for our margins just to be clear about that.

We get -- we'll talk about the New Power Systems at some point.

I'm not allowed in the videos for a good reason. But yes, I think we've been fortunate to avoid kind of widespread shutdowns because of the chip shortages and other electronics that are plagued, particularly the pass car business and some of the players. But it has been -- this time last year was a period of high anxiety right through the holiday period kind of studying what chips were on which engine [indiscernible] a leadership team. Were we going to get through Q1? Were we going to get through Q2? It was very much on a knife edge, it doesn't feel like that today. We're not having those kind of -- I mean, we literally we're meeting daily or every other day right through the -- so it doesn't feel like that. There has been an improvement in the continuity of supply. I would say the biggest challenge we face today, part of which showed up in our Q3 results, which were not as good as we hoped, it was just the capability of the broader supply base to deliver exactly the number of parts we want every single day. So we won't shut down, but still a lot of chasing, encouraging, coordinating suppliers. Part of that's due to labor shortages here in the U.S. So that drove some inefficiencies we didn't have like days or weeks down, but it created some inefficiencies. So I think, touch wood, that is improving. And that will be an important contributor. Still, I would say electronics out of Southeast Asia remains probably the biggest single concern, but it, touch wood, it does improve through the course of the year.

And as we think about 2023, do we assume things continue to improve? Or do you assume still somewhat organized chaos?

One thing, at least I'm reading the headlines that some of the customer segments, for some of these electronics that are not truck, the demand seems to be leveling off or declining. So I'm hoping we're moving up the priority for focus because it often for some of these electronics, we might be the biggest buyer in the truck industry and a pretty small buyer relative to some of the other applications. I'm hoping we're moving up higher up the priority chain. So right now I'm not anticipating more stress on supply going into next year. Demand-wise, we're probably most bullish about North America.

Okay. So let's talk about North America because just what your customers are telling you about spending in 2023, both on the heavy and on the medium-duty side. Obviously, the debate amongst investors is still the macro. I don't feel like I've heard a lot of macro deterioration from talking to investors, but how are you thinking about the heavy and medium-duty set up for 2023 in the U.S.?

Yes. So yes, I share some of that concern about instinct would say under a normal cycle, there'll be more alarm bells going off within the halls of Cummins because we'd have probably had an extraordinary peak given the amount of demand, and we'd be more worried about the downside. But because the industry is being constrained, we enter a period of -- have it into 2023 with a pretty robust backlog and arguably, the biggest backlog in medium-duty trucks we've ever seen. And atone from the end users beyond the OEMs, some of the large fleet operators that they want more trucks. So for now the top -- one of the top 2 things, I think, that Jen is facing with customers, every conversation is how can you get me more product? How can I get more axles, how can I get more transmissions, how can I get more engines? So it feels very robust, at least for the first half of the year given the order backlog, all through 2022, our OEM customers have been saying more demands coming, we'll see later in the year. But they were confident that the supply chain capacity was putting customers off from ordering more than we saw last month.

In the past couple of months orders have been through the roof.

Through the roof. So they've been right. They've been absolutely right. And so -- and then they depend on us for a large proportion of their engines depending on which customer it is. So yes, right now it's all about can we deliver more.

So your visibility within the U.S. would be through the first half, at least for 2023.

As far as we know, right now. Now I think if you -- some our customers, they might even be more bullish about that, but I would just say, at least through the first half of the year seems strong.

Okay. And then one of the themes you saw over the past couple of -- or this past year, which I think was a positive for margins for the group were, that OEs were prioritizing heavy-duty production versus medium-duty production. Do you see that playing out again this year? Or do you see -- I mean there's still usually be concerned about medium because of what we're seeing on consumer, but no one serves those customers. So I'm just trying to think about mix heavy versus medium as you think about 2023, is that a negative for your margins? And then we'll talk about China.

I don't think it's so dramatic, it's not a dramatic factor.

Okay.

I'd add, Jamie. I think it's balanced out from the prioritization standpoint, we're medium. It's going back to more of the norm, where medium and heavy are balanced for the OEMs and that's a positive for us. And medium has a backlog for the -- normally doesn't operate with a backlog. Now --

So how far are we at a medium?

It's comfortable through the first half, again. So -- but it's looking -- to your point, it's usually the ones, the canary that we watch to see if there's going to be a downturn that would go first. And...

You're not seeing that?

It's stronger talking to our own highway leaders, it's stronger or as strong as heavy.

So I think as I was sitting here last year during this conference virtually, the view on China was China is going to be weak in the first half of the year and then everyone was playing for the second half recovery. Obviously, China has been disappointing, both on the truck side and on the construction side. I think you said it's the lowest level of demand you've seen in 10 years. So are we at bottom, I mean how do you think about China in 2023?

Yes, there's no visibility yet to put momentum. But we'd have to bet on that at some point here, not too distant future. But right now we don't see it. And if anything, with the rise in COVID cases, we're seeing more shutdown restriction on employee moves, I mean, not unique to Cummins, but it isn't getting any easier in the near term and you -- well, we can all see a sense of frustration for the people just trying to live their lives. It's very hard. It's just a hard environment. I'm not -- like, that's not me whining about the rest of this year. I'm just -- we have no signs of the upward momentum going into next year yet. At some point, it will come. But the more the terms being zero-COVID, zero-COVID versus economic stimulus.

Okay. And then before we shift off the macro, why don't we just talk about the demand trends you're seeing on the off-highway side and business, mining, oil and gas and what your expectation is for 2023?

Yes, it would be very hard to get -- if you wanted one of our larger engines now it would be -- you'd have to wait quite a while, you'd have to get in queue. The demand is very robust. Again, we can have an economic downturn. There can be cancellations. But today, we don't see that. So you couldn't get probably a new product in most categories with a brand new order in the first half of next year in off-highway.

Okay. Does anyone in the audience have a question? No? Okay. So why don't we shift to -- your market share has been pretty high in the U.S. as you've been able to serve your customers. Can you talk about how we think about market share in the different parts of your business? Is there -- should we assume it's steady in 2023? Are there any opportunities for you to improve your market share?

Yes. There are always opportunities. I think they're on the incremental side since we've been so successful in over an extended period of time. I would say we still see the most upside, I think, in China over a longer period of time. Obviously, we have a lot of the momentum in medium-duty truck in North America...

You can't really gain that much more.

Yes. So the market demand is going to drive us. Our content on trucks is going up, of course, with the Meritor acquisitions, that's all good. So I think really significant shifts. We're really talking about this bigger backdrop theme of should OEMs have the capacity to invest in new technology combustion engines, we're a natural choice if they want to do less of that. So we're going to continue to keep knocking on doors and trying to find win-win solutions. So that's probably the biggest theme we continue to work on. But I don't see any significant changes to the market share in the near term.

And then understanding you've been very successful gaining engines -- sorry, gaining engines, well, you have been -- but gaining market share on engines. When you think about the wins of Daimler and [ Isuzu ], what inning of the ball game are we in? And then can you sort of help investors frame what this means for you in terms of incremental earnings or making your earnings power more resilient, I guess, as we think about the next 3 to 4 years?

Yes. So we are in this window now because certainly in the U.S., you've got new regulations, '24, 2027. Those are still being baked, but those are going to be investments required that are right in front of the OEMs now. That means you can't just stay in combustion engines and kind of milk those current technologies till the end, you've got to invest more to stay in. So this next 3-year window is going to be an important choice. Of course, we're already developing engines for those emissions regulations. So we're often investing. We'll probably see a step up in CapEx and R&E next year because we've got new platforms coming out. But in terms of an inning, yes, I'd like to think we're only in -- which game are we playing, Jamie?

Baseball.

Baseball.

Do you know baseball? Do we have to -- I don't know soccer so like, we got to help each other out here.

I think there are --

9 innings, there's 9 innings in the baseball game, okay.

All right. There's 9 innings, there you go. I think -- well, I don't think -- I think we're still in the first half of those innings, I hope.

Okay. Okay.

I think the other thing is we -- as part of the announced deals and some of this, we're winning business outside North America, where, hopefully, from an engine perspective, the tail for combustion engines, our view is that's probably longer. So we've got more business to come in '27 and onwards in India, Latin America.

Okay. And then one of the big debates on your name is, obviously, Cummins has been very successful dominating the diesel engine business, you continue to gain share because your customers can invest in diesel and in alternative power trains. And so the pushback I get on your name is, if they gave Cummins all of the diesel engine business, why the hell are they going to work -- sorry, I shouldn't say that, why are they going to work with you on EV or fuel cells? So how do we think about -- what is your answer to that? And are there additional opportunities for you to announce partnerships with some of your core -- with your core customers on the alternative power side?

And that's a common set of questions. I understand why those questions are out there. One of the themes as to why we're picking up more combustion engine business is that, amongst other things, scale is really important. And we've had superior scale. Medium-duty was the most obvious example that we were -- there was a clear distance between Cummins and Daimler, that Daimler were clearly the #2 and yet they made the choice that they didn't want to continue. So everybody else's economics, it's hard to imagine why they're advantageous. Scale is important. So the question is who's going to have scale and technology and distribution and footprint in these new technologies. And I think one of the things that we felt confident about as we were hiding behind our sandbags, whilst the limitless capital was available for startup. So there's just practical barriers. And one of which is having money to invest and sustainability. And another thing is just a lot of -- going to be a lot of variation across application across region. So we felt for some time that if we get the technology right, we've got all the other things that the OEMs would consider. We recognize we haven't landed a big OEM announcement on the EV side. And let's see if we can make some progress on that going forward. Our view is the landscape. My main point is that the landscape is not defined. It's not defined. It's not certain.

Well, isn't it too early to make an announcement anyway, like do they even matter now?

No. But I do think -- I think -- in our case, people do look to customer announcements because...

They do.

Right, and they usually only come when they're fully baked. I'm not predicting when I'm saying we're working hard on our technology and all these other things, our view is the market is not yet set. And so let's see how that plays out. But right now the upside for Cummins is really on hydrogen production, which is not a transition story. That's a new avenue for revenues work. Whilst we are continuing to invest in BEV and I expect our battery electric sales will grow next year, there's even more impetus on the hydrogen side, which we're investing. We're more now let's hurry up now with the capacity in manufacturing.

Yes. So let's talk about the electrolyzer business because I think in Belgium, you have 1 gigawatt in the U.S., you're starting manufacturing, I think, 500 megawatts. What other -- can you talk about the investments to get that capacity when the plants start producing and sort of your backlog in the electrolyzer business?

Yes. So I think over the last few months, we've announced 3 different capacity expansions in electrolyzers and it's become -- the demand is very, very strong. Europe, North America was strong and then Inflation Reduction Act just spread it on even further China as well. And so it's become who can ramp the capacity of both manufacturing capacity as well as supplier capacity. So we're seeing some good step-ups. We're looking to get to the capacity between 1.5 and 2 gigawatts by the end of next year. So it's just getting ahead of the ramp in revenue because you can think about it, the general rule of thumb now is about $1 million a megawatt in revenue. So we see this market growing rapidly and the demand keeps going up. So we're getting ahead on the capacity side. We feel that's an advantage for us. We know how to manufacture. We know how to source where some of our competitors are newer to that game. So I think -- and we're building it out in various pieces, including in the U.S.

And then you've also had some successful customer or partnerships like Sinopec, are there any holes? Is that something we should be looking to in 2023?

Not particularly in holes. I think we -- for Europe, partnering with Iberdrola in Spain, in Chevron globally, Sinopec in China and some others like NextEra in utility. I think we have a really good -- some good partnerships. We just announced another one, more on the vehicle side with Tata in India. So it's still not as developed in India, but we see some potential there. So nothing imminent. We think we already have a marquee set of partners, and we'll continue to work with them and keep pushing forward.

And then, Mark, how do we think about a path to profitability within your electrolyzer business? And the other -- I think investors are trying to understand is it's sort of a different business model for Cummins, where is the risk inherent in the electrolyzer business?

Yes. So I think what we're going to watch for as we're going, how are we progressing on the gross margins. That's what I'm focused on, is we're actually building and shipping products. Obviously, we'll continue to invest. So it probably won't be enormous earnings next year, but we're looking for progression on the gross margins as we really start to ramp up the production. You're right. Well, it's different from our more routine complicated, but routine engine business because you're really involved in some pretty large projects. And so there's a variety of ways you can participate simply providing the electrolyzers, providing a more bigger project type process, some of which we have those capabilities already in our Power Systems segment. So there is a degree of variability. We set our parameters around kind of commercial risks and opportunities we're willing to look at as we go into these partnerships. So it is -- we're definitely mindful of the commercial risk. I'm not an engineer and I don't want to oversimplify electrolyzer, but I think the manufacturing of them isn't -- that's something that's well within our capability. It's really -- we acquired a company that was very focused on developing new technologies. They had a plan to scale up the size of the electrolyzers. That's what we're working on, on the development side, but the manufacturing side I'll be pretty confident that's not an area of risk. So we are very focused on the whole package. As always, it comes into the sale, we don't recognize anybody for sales. We don't compensate anybody for sales. What we do look for, of course, that we have to have sales, you have to have customer wins, you have to have momentum and I think that is -- there's no doubt that's building on the electrolyte side. So I think most important to me is to be able to talk to investors about those positive gross margins as we move up that scale.

Let me just pause for a second. Sorry, does anyone in the audience have a question? Yes, sorry, go ahead.

I'm [ Ari Rosa ]. I cover the transportation sector. So I'm curious as we see -- you talked about the backlog being pretty robust. But obviously, we've seen trucking rates down pretty considerably in the United States. And some of the carriers that we talk to say they continue to have trouble securing new trucks and new equipment. To what extent do you worry about maybe the backload eroding and maybe some of the -- some of that cycle risk working its way through as we see kind of some weakness in trucking rates?

Yes, I think it's -- with these cycles, it's a question of when and what's the trigger. So I agree, spot rates and other things used prices we've come off, these absolute frothy peaks. But what gives us confidence in the near term is the actual demand for trucks continues to go up. You do see cancellation rates rise due to a slowdown, but the bigger factor is just the number of orders tend to drop off fairly precipitously once confidence evaporates out of the market. So yes, we watch those order numbers closely. Of course, the OEMs are closest to that. And all I can say right now is, it's not just that they are saying to investors it's bullish by telling us they need more engines because collectively, we've not been able to supply the market. If the economy rolls over in the U.S., I imagine the orders will drop very sharply. What the OEMs do, just smart is used the backlog as a little bit of a buffer. So they'll say to us, Cummins build us 30 engines a day for 90 days, then build us 20 or 10 to try and run in a much more managed way than the volatility in the order book. And I think that's -- we've really seen in the last couple of cycles that the highs haven't been as high. Now that partly, that's supply constrained, but the lows have been higher as well, which has taken some of the volatility out of the earnings process. But yes, eventually, if the economy slows, we will see lower orders and we'll be downshifting and then we'll go back up again. That's the joy of this business.

Let's talk about the joy in New Power Systems. Just the setup, we've been losing money in this business for some period of time. But at what point do the losses lessen?

New Power.

For New Power, yes. Like when do we -- when is the -- not the trough, but like the worst year for losing money, when do we start to see a trajectory for things to get better? Is 2023 a bigger loss than 2022?

Certainly today, I would expect next year to be a bigger loss than this year and then hopefully then we'll start to move on the downslope.

Okay. So...

Down slope of losses.

Down slope of losses, okay.

Movement towards positive earnings.

Okay. All right. So that's your headwind in 2023?

I'm excited about Power Systems, so they get that.

New Power Systems.

The New Power systems.

New Power Systems, now. Okay. So why don't we shift to Meritor? Any surprises since you announced the deal? Can you talk about potential revenue synergies on the core business, like the traditional axle business? Where is there the opportunity? And then how do you feel like Meritor improved your competitive positioning on the EV side? Is there anything else that you feel like you need to do? So start with core, and then we can go to EV.

Yes. I think it's been a lot of work as you know -- especially for our Cummins Meritor employees now being absorbed and the company has been a lot of focus on initial synergies and reducing cost where we can. I think we're really in the process now of getting out and talking more to customers in different parts of the world about the opportunities. On the EV side, the honest answer is, yes, we're now combining their business with our business. We've got ideas, we've got plans. We now need to implement them. I would say the challenge in the short run is that that business run into supply chain issues just as we had done a bit earlier. And so the margin has dipped from pre-acquisition levels right at the time we acquired in England probably there's a law, a Murphy's law or something equivalent that we call it in England. So we've had -- we've been working closely with the team there because demand is very high. So we've been working to improve those margins. We've seen consistent improvement as the teams have worked on operational. And I think they were a bit out of the sync on price cost. So we've been working through that. We're seeing margins improve. So that was not the most fun thing to happen, but that's what we do work on operations, drive it forward. The overarching theme, I think from -- I hear back is, yes, people think Meritor is now part of a much more financially robust organization. They've done a good job, but the EV side probably needs more investment. And I think as a stand-alone, they were very focused on margin improvement, did a good job. But our view is probably need to accelerate some of the investment on the EV side, which will contribute to some of the higher losses next year. But demand remains very, very strong, and there are a limited number of players who can satisfy that demand. So today, it's more about can we get production up? And then can we bring to life these actual development plans to optimize the future EV solutions, but I haven't seen anything that changes our confidence. It was through nobody's fault, it was frustrating to see the dip in margins, but we've got that going in the right direction now. So I'm feeling a lot better here than I was 90 days ago when we first started get our arms around it. All the employees know where they sit in the org structure. So we've got all that aligned and communicated. So I think more to come on, can what are the new platform wins. There's been a lot to get our arms around. Jen, of course, will be leading conversations with customers and Amy about new platforms, but just build more of everything e-axles, regular axles today. And then outside of the e-axles of course the strengths we have is our relationships in emerging markets. So that was one of the benefits I think we're going to saw come back on the transmission side, they are great. We had market access.

So we can do that again.

We think we can do that again. And I do get some questions about isn't just like a substitution story EV versus old axles, because this is -- we're all worried about substitution. But it's really more of a content story, right? There are elements of the axle that are common between the new -- it's really, in my opinion, more akin to a component style content story. Albeit it's on new versions of trucks, it's not on existing trucks. So I think that's an important part of the narrative going forward.

Okay. And with 4 minutes, does anyone in the audience have a question? Yes?

How do you feel about your leverage right now? Are we going to [indiscernible]?

Really good questions. I think right now just given the macro headlines, we probably will do some debt reduction over the next 18 months. It's important to us to keep returning capital to shareholders, but we need -- probably need to just delever a little bit over the next 18 months. So normally, that hasn't been a factor. It's been all share repurchases and dividend growth. The dividend growth will be important and then a little bit of some delevering is going to move higher up that list over the next 12 to 18 months. But the good news is our core business continues to generate more cash than it needs. So a little bit of adjustment to the debt levels, I think, is appropriate and then we should be back on to returning higher levels of capital. That's my expectation right now.

And then I guess, Mark, both distribution and your power -- traditional power systems business, you need a new title for New Power Systems. It's just...

I'm not allowed to name any...

It's like New Power Systems, Power Systems. Anyway, there's been improvement in margins in your distribution in your Power Systems business. Is there any more self-help opportunities within those 2 segments? Or is it more we just think about it a function of volumes, what you mean in incremental margins, distribution is different, but yes?

I do think there is some more self-help probably through my career, not through the lack of trying from many, many people, but the performance of the Power Systems business has been too inconsistent for our liking. And so there's been a strong focus on getting those margins up. Q3 was a nice boost. Really, demands helped a lot. And so we've pushed the pricing lever pretty hard. That's been the fundamental benefit this year, along with strong demand. I still think there's some more self-help that can come along in Power Systems. And yes, in distribution, it's taken a while, but done a great job in really improving the margins in North America, how can we take some of those learnings and more broadly apply them across other parts of the world. And Tracy and the team also done a good job, quite frankly, derisking our appetite in Africa. And you've got a long memory and we've had some -- and so do I -- because I have to live it. We have some big appetite for growth in Africa. And yes, we experienced some volatility in earnings just because of the currency and capital restrictions. So I think we've derisked our approach there, and that's helped the underlying earnings. We don't really have any other areas with such volatility, but I think we've got areas where we can drive more operational improvement going forward. So yes, we're definitely pushing that. And those 2 businesses are very closely aligned. The distribution business sells most of our power handles are selling arm and our relatively new leader of the Power Systems business, Jenny Bush, led that transformation work in North American distribution. So she is the right person to help keep pushing those organizations closer together, serve customers better and get our margins up.

Okay. And so with 40 seconds left, understanding Tom and Jen partnered in the Destination Zero, that's what we're calling it, strategy. What do you see? Every CEO brings a different nuance even if the strategy is basically the same. Like what are you thinking -- how do you think about Jen relative to Tom in terms of what investors should expect?

Yes. It's an interesting question. I think --

Sorry to put you on the spot.

No. But I think Jen's deeper in technology. Tom was not -- he was obviously very aware of technology trends. He had this incredible presence around global opportunities. This drive for things that you maybe sit there and think, I'm not sure we can do that. But he had this ability to drive this to another place. I think where Jen brings at this juncture, it's really important is kind of depth on technology to help us make those choices about what's going to win and what's going to win for customers. That's going to be really important. And I would just say both great people and a big part of Jen's focus is on our people, right? That really means a lot to her. She grew up in Columbus, Indiana. The company means a great deal to her and the people. She lives amongst so many of our workforce, you saw with the onetime recognition employees that was very much driven by Jen listening and knowing that we have to have a very capable workforce in what's an increasingly competitive marketplace. That's a really big focus. And I don't need to say Tom was a huge advocate of leadership development. I think Jen's continued to that, but also very focused throughout the organization.

Okay. Well, that...

Tom's only a phone call away. I told him to see [indiscernible].

Tell Tom I said Hi. Well, our 35 minutes went quick. So Mark and Chris, thank you for your continued support of the Credit Suisse's Industrial Conference.

Absolutely. Thank you, all.

Thank you for joining us this morning.