Cummins Inc. (NYSE:CMI) Q4 2022 Earnings Call Transcript

Cummins Inc. (NYSE:CMI) Q4 2022 Earnings Call Transcript February 6, 2023

Operator: Greetings, and welcome to the Cummins Inc. Fourth Quarter 2022 Earnings Conference. At this time, all participants are on a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chris Clulow, Vice President of Investor Relations. Thank you. Please go ahead.

Chris Clulow: Thank you very much. Good morning everyone and welcome to our teleconference today to discuss Cummins’ results for the fourth quarter of 2022 as well as the full year performance. Participating with me today are Jennifer Rumsey, our President and Chief Executive Officer; and Mark Smith, our Chief Financial Officer. We will all be available to answer questions at the end of the teleconference. Before we start, please note that, some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties.

More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q. During the course of this call, we will be discussing certain non-GAAP financial measures and we will refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today’s webcast presentations are available on our website within the Investor Relations section at cummins.com. With that out of the way, I will turn you over to our President and CEO, Jennifer Rumsey, to kick us off.

Jennifer Rumsey: Thank you, Chris. Good morning. I’ll start with a summary of 2022, discuss our fourth quarter and full year results and finish with a discussion of our outlook for 2023. Mark will then take you through more details of our fourth quarter and full year financial performance and our forecast for this year. Last year was an incredibly exciting one for Cummins and our stakeholders. We made significant strides in our inorganic growth strategy, most notably through the acquisitions of Jacobs Vehicle Systems, Meritor and the Siemens Commercial Vehicles business. We also navigated complex global supply chain challenges, advanced our preparation for the separation of our filtration business and transition from Tom to me as the CEO.

We accomplished all of this and delivered record revenues, EBITDA, and earnings per share in 2022. We did so with the focus on the exciting opportunity in front of us to lead the industry to a broader clean economy and do so in a way that is best for our stakeholders and the planet. Decarbonization is a growth opportunity for Cummins, uniting our business and climate goals. In 2022, we launched our long-term decarbonization growth strategy, Destination Zero, which includes making meaningful reductions in carbon emissions through advanced internal combustion technologies widely accepted by the market today, while continuing to invest in and advance zero emissions technologies ahead of widespread market adoption. As part of our organic growth strategy, we unveiled the industry’s first unified fuel-agnostic internal combustion powertrain platforms, and we continue to see momentum in our electrolyzer technology and green hydrogen production opportunities.

Demand for our products remains strong across all of our key markets and regions with the notable exception of China, resulting in strong revenues in the fourth quarter. Fourth quarter revenues totaled $7.8 billion. Excluding the Meritor business, revenues for the fourth quarter of 2022 were $6.6 billion, an increase of 13% from the fourth quarter of 2021, primarily driven by increased demand in many of our North America markets. To provide clarity on the fourth quarter and 2022 full year operational performance of our business and allow comparison to our prior guidance, I’m excluding the Meritor operating results and associated acquisition and integration costs, the costs related to the separation of the filtration business and the costs associated with the indefinite suspension of our operations in Russia.

Mark will provide more detail on the reported results in his comments. With these exclusions considered, EBITDA was $1.1 billion or 16.1% of sales in Q4, above our guidance of 15.5% and stronger than the $705 million or 12.1% reported a year ago. EBITDA and percentage improved due to an increase in gross margins with positive pricing, higher volumes, lower product coverage costs and some improvement in logistics costs, all of which offset increases in material costs. Gross margin improvement is key to meeting our long-term goals of increasing the returns in our core business while transitioning our New Power business to break even EBITDA by 2027. In the fourth quarter, Meritor operating performance and financial results showed improvement, and we continue to accelerate value capture opportunities across the business.

Our employees have done an excellent job in integrating the Meritor operations and people within Cummins and continue to make strides in identifying cost reduction opportunities. We remain confident in our ability to achieve the $130 million in pretax synergies we referenced upon completion of the acquisition. And in addition, we expect to deliver incremental tax synergies as we integrate the business. Excluding Meritor, 2022 revenues were a record $26.2 billion, 9% higher than 2021. Also excluding Meritor, the costs related to the planned separation of the filtration business and the impact of the indefinite suspension of our Russia operations, full year EBITDA was $4 billion or 15.1% of sales compared to $3.5 billion or 14.7% of sales in 2021.

Improved volumes, better price realization and an improved supply chain environment more than offset higher compensation expenses, increased material costs and lower joint venture income for the year. EBITDA percent improved year-over-year in Engine, Power Systems, Distribution and Components segments. Leading the way was the Components segment, which delivered 150 basis points of EBITDA margin expansion. The Power Systems business finished 2022 with another solid quarter and delivered full year EBITDA of 12.2%, up from 11.2% last year. The improvement in performance in this segment over the past six months is encouraging, and you will see from our guidance that we expect further margin gains this year. EBITDA margins in the distribution business increased by 110 basis points.

Our reported full year 2022 results include five months of operational performance for Meritor or $1.9 billion of revenue and $26 million of EBITDA, including $115 million of acquisition, integration and purchase accounting related costs. Now, let me provide our overall outlook for 2023 and then comment on individual regions and end markets. Our 2023 guidance includes our expected results of the Meritor business and excludes the costs or benefits associated with the separation of the filtration business. We are forecasting total company revenues for 2023 to increase 12% to 17%, compared to 2022 and EBITDA to be 14.5% to 15.2% of sales, driven by the inclusion of a full year of sales from Meritor, continued strength in the North American truck market, improved demand in power generation markets, overall pricing improvement and slow improvement in the China on-highway markets.

Industry’s production for heavy duty trucks in North America is projected to be 260,000 to 280,000 units in 2023, a range of a 5% decline to 2% improvement year-over-year. In medium-duty truck, we expect the market size to be 125,000 to 140,000 units, flat to up 10% from 2022. We expect our deliveries in North America to continue to outpace the market, as the engine partnerships we announced in 2021 continue to phase in. Our Engine shipments for pickup trucks in North America are expected to be 140,000 to 150,000 units in 2023, volume levels consistent with 2022. In China, we project total revenue including joint ventures to increase 7% in 2023. We project a 15% to 25% improvement in heavy and medium duty truck demand and 10% to 20% improvement in demand in the light duty truck market, coming off the low market levels in 2022.

Industry sales of excavators in China are expected to decline 25% to 35% in 2023 as the market adjusts to new emissions regulations and digests inventory on hand. We are watching the situation in China closely, with ensuring the safety and well-being of our people as our first priority. The change in the country’s COVID lockdown policy could positively impact our operations in the coming months. The current events make it difficult to gauge. The markets within China are at a low point, as we close out 2022 and our guidance assumes a slow recovery in 2023. In India, we project total revenue including joint ventures to be up 1% in 2023. We expect the industry demand for trucks to be flat to up 5% for the year. We project our major global high-horsepower markets to remain strong in 2023.

Sales of mining engines are expected to be down 5% to up 5%, dependent upon the trajectory of commodity prices and supply chain improvement. Demand for new oil and gas engines is expected to increase by 15% to 25% in 2023, primarily driven by increased demand in North America. Revenues in global power generation markets are expected to increase 10% to 15%, driven by increases in non-residential construction and improvements in the data center market. In New Power, we expect full year sales to be $350 million to $400 million, more than doubling our 2022 revenues. We have a growing pipeline of electrolyzer orders, which we expect to convert to backlog and to be delivered over the course of the next 12 to 18 months. At the end of the first quarter of 2022, we shared that we had reached the milestone of a $100 million in electrolyzer backlog.

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This tripled to $300 million at the end of 2022, demonstrating the strong momentum in this market. With demand continuing to rise, we are focused on adding capacity for electrolyzer production. During 2022 we announced several capacity expansion investments and expect to have more than two gigawatts of scalable capacity in the 2024 to 2025 timeframe across Europe, North America and China. Additionally, we will continue to deliver battery, electric and fuel cell systems along with electric powertrain technologies as adoption continues in the transportation markets. As mentioned, Meritor results are included in our overall guidance for 2023. We are continuing to drive improvement in our margins post-acquisition and expect Meritor to be accretive to earnings per share in 2023.

We will continue to provide updates on the progress of our value capture initiatives, which will be focused on the portion of the business within our Components segment. Within Components, we expect Meritor to add $4.5 billion to $4.7 billion in revenue in 2023 with EBITDA margins in the range of 10.3% to 11%, an improvement from the comparable 2022 EBITDA margin of 7.2%. The electric powertrain portion of the Meritor business has been integrated within the New Power portfolio with projected 2023 EBITDA losses of $55 million included in the overall guidance for that segment. In 2023 we anticipate that demand will remain strong in most of our key regions and markets, especially in the first half of the year. While some macroeconomic indicators have weakened in recent months, we have not seen a significant change in customer orders at this time.

In summary, we expect full year sales growth of 12% to 17% and EBITDA to be 14.5% to 15.2% of sales. We have taken a number of actions to improve our EBITDA in 2023 and expect to generate very strong incremental margins within our core business and improve the margins of the Meritor business while continuing to invest in our New Power business. Having effectively managed through the challenges of the past couple years we expect improved performance in 2023 and are well positioned to invest in future growth while continuing to return cash to shareholders. Now, let me turn it over to Mark, who will discuss our financial results in more detail.

Mark Smith: Thank you, Jen, and good morning, everyone. There are four key takeaways from my comments today. First, we delivered strong results in the fourth quarter of 2022, exceeding our own projections for revenue and EBITDA from three months ago, and we delivered stronger margins Engines, Components, Distribution and Power Systems compared to a year ago. Second, we continue to make good progress on the integration of Meritor and we remain on-track to deliver $130 million of pretax synergies by the end of year three. We returned $1.2 billion to shareholders in 2022 in the form of dividends and share repurchases. Finally, demand for our products remains strong, supporting increased revenues in our core business and New Power and growth in EBITDA and earnings per share in 2023.

Now, let me go into more details on the fourth quarter. Fourth quarter reported revenues were $7.8 billion and EBITDA of $1.1 billion or 14.2%. For the full year, revenues were $28.1 billion and EBITDA of $3.8 billion or 13.5% of sales. Also in the fourth quarter, Meritor generated $1.2 billion of revenue, $60 million of EBITDA, after incurring $27 million of acquisition and integration related costs. Our fourth quarter results also included $19 million of costs related to the planned separation of the filtration business. Full year 2022 results included five months of operational performance for Meritor, yielding $1.9 billion of revenue, $26 million of EBITDA, reflecting $115 million of acquisition, integration and purchase accounting related costs.

We will all look forward to a cleaner set of numbers in 2023. Our full year 2022 results also included $81 million of costs related to the planned separation of the filtration business and $111 million of costs related to the indefinite suspension of our operations in Russia. To provide clarity on the fourth quarter and 2022 full year operational performance of our business and allow comparison to our prior guidance. I am excluding the Meritor results and the separation of filtration and the indefinite suspension of Russia in my following comments. But hopefully, you are clear after my earlier remarks about the magnitude of those — each of those items. Fourth quarter revenues were $6.6 billion, an increase of 13% from a year ago. Sales in North America were up 25%, driven by continued strong demand in truck markets.

International revenues decreased 1% with stronger demand for power generation and mining equipment in most markets, offset by declines in China and, of course, the impact of our suspension of our operations in Russia. Currency movements negatively impacted sales by 4% due to a stronger U.S. dollar. EBITDA was $1.1 billion or 16.1% compared to $705 million or 12.1% a year ago. EBITDA increased by $359 million due mainly to improved pricing, higher volumes, lower product coverage expenses, all of which contributed to stronger gross margin performance and more than offset higher material costs. Now, let’s go into our income statement, a little more detail by line item. Gross margin of $1.7 billion or 26.3% of sales increased by $420 million or 380 basis points from a year ago.

Selling, admin and research expenses increased by $52 million or 6% due to higher compensation and research costs as we continue to invest in new products and capabilities to support future profitable growth, particularly in the Engines and New Power segments. Joint venture income decreased $28 million due to lower demand for trucks and construction equipment in China. Other income was $44 million, an increase of $13 million from a year ago, primarily due to higher pension income. Interest expense increased $58 million, largely driven by the financing costs associated with the acquisition of Meritor. The all-in effective tax rate in the fourth quarter was 17.2%, including $52 million or $0.36 per diluted share — favorable discrete items. All-in net earnings for the quarter was $631 million or $4.43 per diluted share, up from $394 million or $2.73 a year ago.

Operating cash flow in the quarter was an inflow of $817 million, including Meritor and, $85 million higher than the fourth quarter last year, driven primarily by higher earnings. For the full year €˜22, revenues were a record $26.2 billion or up 9% from a year ago, with sales in North America up 18% and international revenues down 2%. Currency movements negatively impacted revenues for the full year by 2%. EBITDA was $4 billion or 15.1% for 2022 compared to $3.5 billion of 14.7% of sales a year ago. Improvements in Components, Distribution, Power Systems and Engine margins were partially offset by increased investment in New Power and more than $100 million of mark-to-market losses on investments that underpin some of our nonqualified benefit plans.

All of that run through our operating EBITDA. All-in net earnings were $2.2 billion or $15.12 per diluted share compared to $2.1 billion or $14.61 per diluted share a year ago. Full year cash from operations was $2 billion, down from $2.3 billion, primarily due to higher inventory levels. Capital expenditures in 2022 were $916 million, an increase of $182 million from 2021 as we continue to invest in new products and capacity expansion critical for future growth. We returned $1.2 billion of cash to shareholders or 63% of operating cash flow in the form of share repurchases and dividends last year. Now, moving on to our guidance for 2023, which includes Meritor, and thankfully, reduces the number of exclusions we’ll have to explain each quarter, and I appreciate your patience as we work through that in 2022.

We are excluding any separation costs associated with filtration, and for now, we’re assuming that the operating results of filtration are in our guidance for the full year 2023, as the timing of that separation is not yet determined. We expect Meritor to add $4.5 billion to $4.7 billion of revenue in 2023. We currently project 2023 company revenues, including Meritor, to be up 12% to 17% and company-wide EBITDA margins expected to be in the range of 14.5% to 15.2%. In €˜23, we expect revenues for the Engine business will be flat to up 5%, driven by continued strength in North American truck market and a modest recovery in China. 2023 EBITDA is projected to be in the range of 13.8% to 14.5% compared to 14.4% in 2022. We expect distribution revenues this year to be up 2% to 7% and EBITDA margins to be in the range of 10.3% to 11% compared to 10.5% in 2022.

Including Meritor, we expect 2023 components revenues to increase 28% to 33% and EBITDA margins in the range of 14.1% to 14.8% compared to 15.0% in 2022. In €˜23, we also expect Power Systems revenues to be up 5% to 10% due to higher demand for oil and gas engines and power generation equipment globally. EBITDA there is projected to be between 13% and 13.7%, up from 12.2% of sales last year. And also this year, we expect New Power revenues to increase to the range of $350 million to $400 million. We expect New Power net losses to be in the range of $370 million to $390 million as we continue to make targeted investments in capacity, technology to support growing customer demand. Our goal remains to achieve breakeven EBITDA in 2027. Our effective tax rate this year is expected to be approximately 22%, excluding any discrete items.

Capital investments will be in the range of $1.2 billion to $1.3 billion this year. We remain committed to our long-term goal of returning 50% of operating cash flow to shareholders over time and have accelerated cash returns to shareholders in recent years above that 50% goal when we have generated more cash than required to support our strategy. In 2023, we will prioritize cash towards dividends and debt reduction following the acquisition of Meritor while continuing to invest to deliver future profitable growth. Having a strong balance sheet is an important asset as we navigate through economic cycles and sustain our investments in new products for existing and new markets. To summarize, we delivered record sales, strong full year earnings in 2022, while managing through supply chain challenges and a very weak demand environment in China.

As we move through 2023, demand for our products remains strong in most of our core markets with good visibility into the first half of the year. We’ll continue to focus on raising margins in our core business, driving improvements in the performance of Meritor, generating strong cash flow and investing in the products and technologies that position us to lead in the adoption of new technologies and penetrate new markets through our New Power business. Thank you for your interest today. Now let me turn it over to Chris.

Chris Clulow: Thank you, Mark. Out of consideration to others on the call, I would ask that you limit yourself to one question and a related follow-up. If you have an additional question, please rejoin the queue. Operator, we’re ready for our first question.

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Q&A Session

Operator: The first question today is coming from Jerry Revich of Goldman Sachs. Please go ahead.

Jerry Revich: I know it’s early post the acquisition of the Siemens propulsion systems and Meritor, but wondering if you could just comment on what the acceptance has been of the products in the marketplace? Post-Cummins ownership, what’s the pipeline from the developments look like? How is that cross-selling working out versus what you folks had expected before acquiring the assets? Thanks.

Jennifer Rumsey: Yes. Thanks, Jerry, for the question. Yes, we are right now really focused on integrating the Meritor business, the Siemens Commercial Vehicle business and the investments that we were already making within New Power and having a number of conversations with our customers on how we bring that together to deliver those electric powertrains and components to meet their needs. So, it brings some strong products, employees as well as customer relationships, and we’re seeing growing opportunities as we have relationships at a senior more strategic level with these customers to grow our business going forward. It’s really early days at this point, so we’ll continue to talk about that as we bring those businesses together.

Jerry Revich: Sounds good, Jennifer, thanks. And Mark, can I ask in terms of the pricing that you’re expecting in €˜23 within the outlook? And if you could just touch on the logistics costs embedded in the guide as well. You folks have been running pretty hot to hit deliveries in €˜22. I’m wondering to what extent does that a tailwind within the guidance?

Mark Smith: Yes, we’ve got about 2% of price cost benefit embedded in the guidance, Jerry. That’s the biggest single driver of margin improvement.

Operator: The next question is coming from Jamie Cook of Credit Suisse. Please go ahead.

Jamie Cook: I guess, two questions. Just given the concern on the macro out there, can you guys speak to by business line where you see the most visibility or where demand trends do you see sort of weakening? And then, I guess, on the engine margin guidance. I guess, I would have thought margins would have been a little better in implied guide just given maybe price cost going away, China improving. So, if you can just help me bridge 2023 to 2022 engine margins what’s implied? Thank you.

Jennifer Rumsey: Great. Thanks, Jamie. Let me speak first to what we’re seeing in the market. And we, of course, are paying attention to some of these macroeconomic trends. If you take just the North America truck market as a starting point, while there has been some decrease in spot rates, we still continue to see healthy freight activity and strong backlogs out through the first half, which gives us confidence that the market is going to remain strong, certainly through the first half of the year. And it’s important to note, it’s just not been a typical cycle for us because for the last two years, we’ve been undersupplying to the market demand. They’ve been using that equipment. We’re seeing that reflected in very high aftermarket demand which continues, and these new trucks provide efficiency benefits to the fleet.

So, we continue to expect strong North America truck market. In the Power Systems business, again, we have a healthy backlog of products and strong demand across many of our markets. Mining, we’re forecasting to remain around flat, but growth in power generation, growth in the oil and gas business. So, we’re feeling pretty confident about that as well. The biggest uncertainty is really around China. And as I said in my comments, we do project some slow recovery throughout 2023. With the lift of the stringent lockdowns that they had in the last couple of years in December, we expect that that may result in economic strengthening and certainly, less operational disruption, but we’re still monitoring what happens with the COVID waves there, is there any government stimulus into the economy.

We feel really well positioned there. We’ve launched our NS VI products, which we think will enable Cummins to grow our position in the market. We’ve launched the automated manual transmission there. We’ve got a new natural gas platform. So, we’re really well positioned as China continues to strengthen and just uncertainty on exactly what the shape of that will look like. I’ll let Mark talk about the margin question.

Mark Smith: Yes. I think the main thing on the Engine business margins is that we haven’t got building a very strong recovery in China. And then the other piece that you didn’t mention, Jamie, is that we’ve got fairly sustained investments ahead of us over the next couple of years because we’re updating several of our platforms. We’ve won a lot of external business, and we’ve got to meet future emissions regulations. So, that’s the only other element that’s running through the Engine business that may not be obvious from the outside, but otherwise, we’ll expect them to do well if markets continue to be strong.

Operator: The next question is coming from Stephen Volkmann of Jefferies. Please go ahead.

Stephen Volkmann: Maybe just following on, on the Engine margin question, Mark. Given what you just described around increased spending, R&D, et cetera, should we think about sort of flattish incremental margins over the next few years, or can it still be better than that, if we have some volume?

Mark Smith: I think it can definitely be better than that. We’re still battling some inefficiencies here and there Steve. We’re still expecting to have aftermarket growth over time. So no, we’re not locked into these margins. I was just trying to be clear on what the underlying factors. I’ve seen a few comments around Engine business margins, but no, I think they can go higher. Getting China, which is the world’s biggest truck market, I know the earnings come through JV, we have the lowest market in a decade. And we think we still got more share to gain there. We’ve got more content in the Components business. So, if I sit here today and say what could be the one thing that could move that could change our guidance most clearly, I would agree with Jen, it would be China, right now. We don’t have visibility. People are more enthusiastic, but the activity hasn’t yet materially picked up. So, that would be one important factor.

Stephen Volkmann: Great, understood. And then, my follow-on maybe a bigger, broader question. But as we start very early days but we start to think about the 2027 emissions regulations, do you guys feel like you have line of sight to what you need to do technically to get there? We’re starting to hear that this is going to be sort of the biggest emission hurdle ever and that some people may have trouble getting there or maybe have some massive costs associated with it, which has some implications for prebuys and maybe whether people do it themselves or outsource it to you, just your big picture thinking on 2027 and how that kind of plays through.

Jennifer Rumsey: Yes. We are focused on continuing to meet more stringent regulatory requirements and do so with products that will provide benefits to the environment and exceed our customer needs. We now have clarity on the EPA 2027 NOx regulations that happened late last year, and they finalize that standard at a 0.035 gram NOx. And our intention is to offer a full product lineup with our new fuel-agnostic engine platforms to meet that regulation, and we’re finalizing our product plans right now with our customers on those. But we really feel well positioned to invest in really as a part of our Destination Zero strategy, reduce CO2 and NOx impact to the environment and offer products — market-leading products to our customers with that regulation.

Operator: The next question is coming from David Raso of Evercore ISI. Please go ahead.

David Raso: Hi. Thank you. The China guide, the up 7%, I assume that includes consolidated and JV revenue, sort of how you usually kind of speak to it.

Mark Smith: Yes.