Cummins Inc. (CMI) Earnings Call Transcript & Summary

So for those that don't know me, my name is Felix Boeschen, senior machinery and trucking analyst here at Raymond James. Today, we're very happy to have Cummins here with us. Presenting is VP of Investor Relations, Chris Clulow. I think what we'll do, Chris, if it's okay, this is more of a generalist conference. So if you don't mind, maybe just giving quick 5-, 10-minute background on Cummins, who you are, key markets you play in, and then we'll kind of go into a true fireside chat after that.

Yes. Sounds good. Thanks, Felix. So yes, thanks for attending, everybody. So yes, we work with Cummins. So we're a global power leader, traditionally grew up in the internal combustion in the diesel space. So far, a 103-year-old company now and really global. So we are operating in 190 countries and territories. So think of everywhere that's legal for a U.S. company to operate, that's where we are. And I think that's one of the big advantages that we have. Two big ones for us is technology-driven, continuing to drive to lower emissions products around the world, and then our global scope and our economies of scale. So we are able to support our customers wherever they may be. And whether that's in power generation markets, whether it's in diesel truck markets, whether it's in mining markets, we can support our customers wherever they are. And I think that's really worked to our advantage. I think over the last few years, it's been a very interesting time to be within the company because we've always had this existential threat of being vertically integrated out. So that was a threat for over 100 years, it seemed like, which has flipped. So as the OEMs continue to have more pressure and more different investment needs, they're looking more and more for us to supply their internal combustion engines, whether it's diesel or moving, as I'm sure we'll get to, natural gas, hydrogen, other internal combustion needs. At the same time, we're building out our new power business, which is electrolyzers, battery electric, fuel cell electric and eAxle. So continuing to make big investments in that space for -- as this transition goes, which we believe will be somewhat long and probably pretty messy as we look around the world. It gives us the advantage of we can offer the products to all of our customers whatever their needs may be. And we know those applications quite well. Having supported, having very strong relationships with our end-user customers allows us to know what they need, even more so maybe than the OEMs now. And I think that really is a big advantage as we continue to support those end users. So it's been a good ride. One of the other things I should mention, given the audience, is we continue to pride ourselves on expanding our margins and growing. We are a cyclical business, so we continue to grow and continue to expand our margins from trough to trough and peak to peak of our cycles, continue to get better and stronger. And I think that's what the mantra we followed for many years and something we'll continue as we go through the next several years. Hope that helps.

No, that's perfect. Before we go into sort of the questions I have prepared, you did have an announcement out this morning I wanted to ask you about. So it's all about, I think, accelerating towards zero emissions. Could you maybe just touch on what it is, what we should expect tomorrow?

Yes. Yes. I wish -- yes, the teaser was out there. So we have an announcement coming tomorrow morning, which is really just showing our commitment to this moving towards the zero-emission space. So I wish I could share more, Felix, but there's more to come tomorrow. Just as we continue to make progress in this space, exciting steps for the company as we're moving forward. So we'll see tomorrow.

Yes. Well, maybe I'll ask it this way, but there's obviously quite a bit happening cyclically but also on the secular side as we think about decarbonization. You obviously acquired Meritor. You talked about eAxles, you talked about electrolyzers. We're also still going through some diesel changes. Can you maybe talk to us how you think about Cummins portfolio broadly as we kind of think about the next 3, 5, 10 years from here?

Yes. Yes. So I think we feel really happy with the portfolio we have now. So it is -- with the acquisition of Meritor gives us a really full set of portfolios for the new power space. We have the eAxle, we have battery electric, we have the inverters, we have kind of the fueling tanks of its hydrogen, fuel cell electric. So we have a full portfolio to add contents to the truck. And Meritor gives us even more breadth to serve our customers with the axles, with the brakes. Same customer base, so we're having the same conversations with them, just a more broad portfolio of products. So we're feeling really, really strong there, but we continue to make investments. I think the big investment we're making now is in our our fuel-agnostic engine, which is same bottom end of the engine and different heads of the engine, depending on whether it's diesel, natural gas, hydrogen, propane, gasoline so we can serve many fuels. And that will help us through this transition, particularly as we go towards EPA 2027, which is the next big emissions change. This change in platform, we've redesigned all of our platforms, really is a big step forward for us. So that's the big investment we're making now as well as the investments we're making in New Power. One of our competitive advantages, I think, is we've always continued to invest in R&D and technology regardless of the cycle and come out stronger as the market cycles. This is another case where I think that fuel-agnostic engine is going to give us more and more advantages, helps us meet emission cycles, helps our customers meet their ESG goals as well as drive their emissions down overall.

I do want to talk about 2027 later on, but maybe before we get there, can we talk about Meritor a little bit? Maybe what has surprised you since the completion of that deal? And then, frankly, I was quite surprised at the margin guidance for 2023. Could you maybe help us understand, how much of that is the core business versus how much of that is some of the synergies already impacting your model next year or this year?

Yes. Yes. So yes, Meritor, it's coming quite well. Integration is going great. I think we are continuing to -- we guided to $130 million savings at the end of year 3. We're feeling really confident with that number. We'll give updates as we get in deeper and deeper. No surprises on the downside, which is good. I think the one thing, as it acquired in, as you saw in our results last year, the margins were lower than probably we all expected. I think we were behind on pricing as we acquired them, something that we hit quite hard and work with the OEMs to address going into this year. So the margin step-up from 7.2% last year up to 10.3% to 11% this year, so it will build throughout the year, a lot of that pricing, but it's cost reductions, to your point as well, Felix. So we're continuing to drive those to help us step up to the mid-10s margin for this year. Over the next few years, we are driving towards getting into our Components average margin, which is 14% to 15%. And we feel confident in our ability to do that, just driving some of the harder synergies, whether it's supply chain and leveraging that or other pieces of the puzzle. But it's going quite well in terms of the integration. I guess one positive surprise is our tax group continues to find some things that we hadn't built into our original models on the positive side, whether it's cash savings or tax savings. I think that we've realized the complexity of the legal structure we need to do some work on, and it will just help us in the long run.

And if I think about the Cummins portfolio, the other big thing that's changing obviously is the Filtration business. Can you maybe update us on the time line there? And then my bigger-picture question is really around capital allocation and what you might do with some of the proceeds.

Sure. Yes. So you may have seen recently, we had the S-1 filed publicly for the initial step of the public offering of the Filtration business. So the first step will be to have the public offering. And it will be soon, I think, is the best answer I can give. We're all set to -- for it to stand alone on its own merits. It will be less than 20% initially that goes through the public offering. And then 6 months later, we'll spin off the rest through kind of a share exchange. So we're working that process. Everything is in good shape. My predecessor in this role is Jack Kienzler, who's now the CFO of our Filtration business, Atmus, as it goes public. So they're, I think, in really good shape. They've been, I know, busy. I talked to Jack yesterday, and he's definitely not running out of gas, but he's certainly tired. So he's he's been hitting the road quite a bit, building this up. I think we're in good shape. What are we going to do with the proceeds? So there's proceeds from the initial IPO and, of course, we'll kind of give them some debt as a parting gift, which they love. So I think that is the proceeds for us initially. And then there's the share exchange, which will reduce our share base in the second step. The proceeds largely will go towards debt reduction, I think, is our primary focus this year given where interest rates are. We're not as leveraged as many of our, I guess, peer companies, but we tend to operate with a pretty conservative and strong balance sheet. It's helped us in the past and something we'll probably work to get back towards.

Yes. I was hoping we could talk a little bit about the current environment as well. I know there's a couple of end markets that you play in. I thought maybe we would start on North American heavy-duty. And I think here's the dynamic that some folks are maybe wrestling with. I think everybody understands there's -- the average age of the equipment has gone up. But at the same time, if you look at some of the freight indicators, it's certainly gotten a whole lot worse. So maybe help us understand, what are you seeing right now from a demand environment, specifically in North America?

Yes. So this is as complex as it's ever been in North American cycles. Because we never did cycle up, we never did peak out, it's -- the cycle has been drawn out. So the economy and the freight rates are coming down a good bit. But the truck ages are quite old. So we -- and we continue to see strong orders. The back half of last year had huge amounts of orders going to the OEMs. January was down a bit, February bounced back up. So it continues to add to the slight confusion as to what the outlook is. Our view is that we think that the market will start to moderate maybe in the fourth quarter, not to a significant degree, but we'll see. We could be wrong on that estimation. The other complicating factor in this is just people are starting to look further out. So the end customers, the OEMs are looking further out and they're even looking at 2027 emissions, which they never would look that far into the future in the past. But going through the past few years where they weren't able to get trucks for 2 years, they're thinking, well, I want to maybe prebuy for before 2027 emissions come and prices go up. So should I start thinking about that now? It's all complicating the cycle and just drawing it out further. And that's the -- on the heavy-duty side. The medium-duty side continues to be strong, and we expect that through the remainder of the year and into next year because it's been deprioritized by the OEMs. The need -- the ages of those weights is even older, and those end customers really need new equipment. So I think that's going to last longer. So it's adding up to the market. We'll remain pretty resilient, barring any big economic downturn. I think the market's in good shape. We do have some slight moderation in our guide for Q4, though.

So I just want to make sure I understand that comment on the slight moderation in 4Q. Was that a comment on North American build rates?

Yes. It's more to do with -- if the OEMs start to see, come 2024, that the orders are going to start to come down and might be a little bit lower, they start to take a little bit less from us. So it might be if they're taking 50 a day, it might go down to 48 a day and they just stair-step it down. So they tend to eat into the backlog and live off the backlog for a while and try to smooth out the cycle, which works well for all of us. The smoother, the better. We're hopeful that the cycles are starting to get more moderated similar to what they are in Europe, where the cycles are a little more gentle because that is to the benefit of the OEMs, the end customers, us. So I think that seems to be the direction we're going now that there's more, I guess, of a European presence in the OEMs we trade on and others.

And I wanted to ask you about your aftermarket business. Can you, first of all, remind us sort of how big is it as a percent of total for Cummins? And then my second question is I would think usually in a cycle, you would see some of the old engines, the parts, maybe come off-line and you would see some weakness there. Have we seen any of that? Where are we kind of in that dynamic?

Yes. Yes. That is one of the early warning signs we look at. As aftermarket starts coming down, in the heavy-duty space in particular, it's usually a a sign that the rest of the market will come down. It's about 30% of our revenues right now, our aftermarket, across the whole company. We own our distribution network largely. So that's why you could -- that's why it makes up a larger piece. I think the 2 big drivers for us in aftermarket are the heavy-duty market, particularly in North America; and then the Power Systems market, the large engine market, mining, oil and gas. Those continue to be very strong. The heavy-duty market is -- continue to be strong. So it hasn't -- we haven't seen any drop-off yet. They continue to do a lot of work, those trucks. The population continues to go up. So where there might be a little bit of a drop-off, the population continues to buoy it and keeps the aftermarket sales strong. So we haven't seen a drop-off yet in that.

You mentioned 2027 earlier, and I want to spend some time on this. Can you maybe explain to us, first of all, what is the emission standard? And how big of a deal is it from a complexity standpoint and maybe from a price perspective, too?

Yes. So the next step in -- as we move to EPA '27 is just another big reduction in NOx emissions. And I think what it takes to get there is really for -- if it's an internal combustion solution, a very, very finely tuned engine. So you can't have any waste, any inefficiencies in the process. That's why we're approaching it with a new platform, a really finely tuned platform, some added componentry, some more aftertreatment on it as well. So whatever emissions come out, go through the aftertreatments and come out and meet the emission standard. So there's some added content, which will drive more pricing. The other big differential is it takes your warranty period up through end of useful life. So from what is maybe a 5-year period now goes to maybe a 10- or 11-year period. So of course, we'll price for that as well. It's something that we've supported our products through their end of useful life anyway. So we have a pretty good view of what that takes. Whether it's -- and that will help us drive some aftermarket through maintenance parts and other things. But I think that's -- those are the big differentiators. So we haven't given a number, and we actually don't know what that number will be and what the price markup will be, but there will be a step-up in price for sure as we go to '27. It's a tough standard to meet. And that's -- I think some of the OEMs will -- might be able to tune their engines, their heavy-duty engines to get there, but it's something that we'll continue to watch.

And so just kind of thinking about 2027 then, you kind of mentioned this when we talked about the North American truck cycle, so to speak. But you talked about customers looking out maybe toward 2027. I mean it sounds like you think there might be a prebuy. To what degree do you think there could be a prebuy? And when do you think that could impact order/build rates?

Yes. Yes. I think the early speculation now talking to the OEMs and the end customers is the expectation is there will be some level of prebuy here, and it could be substantial. And I think that's -- it's starting to, like I said, flow into thinking now. I think it would certainly impact 2026 engines. It will be probably in 2025 as well. Because these new platforms that we're launching to meet the emissions, they're not all coming out January 1. They'll start in late 2025 through 2026. So we will launch them in -- over time so that we continue to support. So we're not launching all new engines all at the same date. So that it will help drive some of that through. But I think it's probably 2025 and '26 will be impacted.

And then we talked about -- your opening remarks were around the threat of vertical integration. And I would think now as the OEMs become increasingly stretched between different powertrain options, they have to spread their R&D dollars across different platforms at this point. How do you think about that actually driving maybe some opportunity for you guys over time? I'm trying to think through -- you announced the big Daimler medium-duty win. Could you replicate some of that on the heavy-duty side? How does that work?

Yes. Yes, that's the hope. That's the hope for us is -- I think the medium-duty side, we continue to gain share in North America, and we're pretty topped out come next year. And then we'll pick up pieces around the world. The medium-duty wins between Daimler and Hino and Isuzu will add about $2 billion in revenue to us by the end of the decade. So we're continuing to stage those in. And the good thing about those wins is we can manufacture all in our own plants. So it's just adding absorption. We don't have to add a bunch of capital to do so, which is -- it's a nice benefit as well. The heavy-duty side, I think, is the -- is kind of the last frontier, where most the OEMs still have their own products. They use ours as well. I think we sell to all of them. But it's their kind of equation they have to add up is, is it worth it for them to stay in. I think the big question for them is what is the total tail for ICE, how long is it going to last. If it's going to be around for a while, they probably want to stay in. But we'll continue to work with them, have had the conversations, continue to have the conversations. If they want to look to us to provide them, we'll be more than happy to at the -- of course, at the right economic deal for our investors and ourselves.

Well, and -- so you mentioned the $2 billion. And I think when you first announced Daimler, I thought the data on it was around 2025. Correct me if that's wrong. But maybe help us understand, as you scale that business, when do you think you'll start seeing more and more volumes come into the Cummins model?

Yes. So the North America will come in over the next year or so, we'll get the remainder of that, bringing the share up to about 95% of the market in North America. And then the European business will come in '25. The South America and India business is scheduled by '27-'28, but that could potentially move forward. We're having those conversations now, so it could be in that '25 realm. We do have the capacity to build it, so we could do it earlier.

Okay. That's super helpful. We're talking about the current environment. So let's ask you about China. So I think, if I'm not mistaken, you guided JV income flat to up 10% year-on-year. Maybe put in context to us what you're assuming there in the Chinese truck market and maybe what you're seeing now just over 2 months into the year.

Yes. Yes. I should mention, we're probably -- for those unfamiliar with our story, we have probably more JVs than anybody's ever seen. That's how we operate in China and in India as well. It's been a tried and true model. It's worked quite well. So what we're seeing in the truck market is we -- in our guidance is kind of more slow steady recovery. I will say that the good thing is like there's no barriers in the way to recovery in China. I think it is -- they've got through the massive COVID super spike over the last couple of months. They've gone through a change in emissions. So the NS V inventory is gone. Now they're on to NS VI. So it's now kind of smooth sailing, and it's just a matter of really consumer confidence coming back. So we're watching that closely. We have a slow and steady recovery built into our guide. What we're gearing up for is a fast -- so we -- with our suppliers, with our capacity, we're making sure we're in a position where we can ramp up fast if needed because they -- we've seen it before in 2020 after -- they went through and went from 0 to a record in a little over a quarter, and we were able to keep up capacity and meet the demand. So that's what we're gearing for. We don't expect that level of quick recovery. It wasn't the healthiest thing in the world because they tend to -- led to 2020-2021 overbuild. So I think it is -- it will be somewhat moderated, but we'll wait and see. My guess is as good as yours at this point, but I -- we're hopeful that we'll see some good recovery this year.

And I don't think I can be here on stage and not ask you about supply chains. Could you maybe talk about what you're seeing out there? It certainly feels as though the OEMs are raising build rates in North America very steadily at this point. Where do you kind of see still pain points? Where has it eased?

Yes. Yes. So I think it has gotten better. I think from -- in terms of flow. Cost is about -- is flattened out as well, plateaued. It hasn't come down yet, but it has plateaued. I think there's still some pain points in -- like for us in the medium-duty space where suppliers, whether they're labor-constrained or they don't want to add capacity at this late in the cycle. So that's capping out things to some degree. Power Systems is in the same space where they lag behind in the supply chain constraints by a couple of quarters. So they're still in the thick of it. I will say it's got -- it has a bit of a ceiling in spaces, but it also has a floor. So we're not as -- it's not a war room every morning for 2 hours like worried about X and Y and Z suppliers. It's more of like more slow and steady, helping them build up a little more capacity and build stability. So it is overall improvement. I think we're seeing a good improvement there. And hopefully, the cost will follow.

Maybe we should talk about price/cost. Could you maybe remind everybody -- sort of you gave 2023 guidance. Could you maybe remind us sort of what you have embedded on price/cost? And then what I'm also specifically curious about is when we went from 2020, '21, '22, you consistently called out premium freight headwinds. And as that normalizes, I'm trying to understand do you keep all that? Do you share some of that with your customers? Just trying to kind of think through margin puts and takes.

Yes. Yes. So I think as we go into this year, we have been, you're right, battling costs for several years. We did better on price last year. We were able to -- price/cost last year was -- for the overall company, it was about 150 basis points better to the positive. This year, it's about 220, and most of that is price. So it's about 200 of price and just a little bit of 20 -- 10 or 20 of cost. So there's still some upside on cost, you're right. The premium freight, the freight costs in general have been a huge headwind over the last few years. We don't expect to get all the way back to where we were in, say, 2019, but there's still a ways to go. I mean, I think they're getting better. It's kind of the 2 edges to the coin. Like we want freight rates to stay high to drive demand, but we also want them to come down to drop cost. So can't have your cake and eat it too, though. So it's -- I think we are seeing some moderation. We've done well on premium freight. That has dropped consistently through last year. Unfortunately, it was offset by standard. So standard rate remained really high last year. That's starting to moderate a bit and come down, but it's not coming down nearly as fast. If we look at '20, 2021 combined and '22 combined, it's probably $400 million of headwind versus like 2019 of total freight. So we've got a ways to go and we think some efficiencies there. That's one of the things that we're -- actually is one of our early cost wins on Meritor is we're putting them on to our freight contracts driving that down. That's really helped us on the cost side.

And then your Power Systems margins looked really strong in the back half of '22. And I know you mentioned it's a bit of a lag pricing mechanism. Could you maybe help us understand, is that really what drove most of it? How sustainable are some of these margins as you think about going into '23, '24, '25?

Yes. I would say that was the principal driver, along with really strong, strong quality results. That was the principal driver was pricing. They lagged behind. It's an area we're hitting harder. So I said 200 basis points of pricing across the company. It's more like 350 in our Power Systems business. So that's where we're pushing pricing harder and faster because it's -- there are long lead times. Like I mentioned, we're taking orders into 2024 now. So these are very long lead times. It's capacitized. Total market is capacitized too. So I think it is something where we can push price a little bit more freely, and we will continue to do so. I think that's -- the focus really now is if we can add a few engines of capacity here and there, we'll be able to sell them for sure because the demand is really high. Whether it's power generation, mining, oil and gas, marine, all of the big markets are up. So there's a lot of demand out there.

And then maybe coming 360 here, we started on decarbonization. We haven't talked about the New Power segment in detail. But could you maybe give us an overview sort of in that New Power segment as you're ramping revenue today? Just talk about the split between electrolyzers, split between eAxles. What else kind of sits in there?

Yes. So the split right now, as I go back to last year, was pretty well split between battery electric, which is mostly buses at this point in time because from a cost competitiveness standpoint, that's where the municipalities will be able to invest. But it's not getting into the truck market yet, other than test vehicles and things like that. The other piece is electrolyzers, which is probably the fast grower, and that's going to be the one that's going to be growing through the course of this decade probably the fastest. Demand continues to rise. Europe, North America and China and now India is starting to chip in a little bit on demand. So electrolyzers is going to be one of the early movers. Last year was sub-$100 million in revenue, but we think it will be $400 million in 2025. And then based on our targets on the low end of the range, $3 billion to $4 billion in 2030. And these are -- we're getting to good gross margins, positive gross margins at quote. So that's getting to a place where it's like turning the corner on profitability, and that will lead the way. And like I said, demand is high. And then the Inflation Reduction Act just fueled even more demand. It actually didn't need that extra kick, but it -- we'll take it. So I think that it's now just kind of project after project keeps coming up, and our focus is on capacity. We have announced 4 capacity expansions last year, and we just continue to build capacity because the demand is certainly there to grab.

And can you maybe talk about -- maybe it's too early to talk about maybe steady-state margins as that business scales. But you are certainly spending quite a bit of money in various powertrain technologies within R&D, and a lot of it sits in that segment. Can you maybe help us understand how you think about the timing of maybe New Power losses peaking? Because what I'm trying to understand, as you grow the revenue, how does -- how do you think margins ultimately pan out? And when do we peak on the losses?

Yes. Yes. So I would say if we don't have a change in strategy, we think that 2023 will be about the peak losses. Might be a little -- in 2024 might be about similar, but then we'll start working our way out in 2027 towards a 2027 break-even point for the whole business. Electrolyzers again will lead the way with gross margin and earnings profitability. And I think that's going to start turning the corner. Now that we're getting up to scale production, automated production, more assembly line production versus cell builds, I think that's really going to lead the way. Long term, we think margins will be comparable. Where we play in the market is going to be comparable to where we sit now as a Tier 1 supplier. So it's comparable to Cummins margins currently is what we're driving towards and we see a clear path towards. Electrolyzers is probably the most current one where we see that. Battery electric and fuel cell has still got some time to shake out in terms of how does that margin shake out. But we'll -- that's the goal for sure.

Chris, that takes us to 30 minutes already. So I'm going to say, thank you very much.