Greetings, and welcome to the Q2 2022 Cummins Inc. Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Chris Clulow, Vice President, Investor Relations. Please go ahead, sir.

Good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the second quarter of 2022. Participating with me today are Tom Linebarger, our Executive Chairman; Jen 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 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 and 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'll refer you to our website for the reconciliation of these measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation 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 Executive Chairman, Tom Linebarger one more time. Thanks.

Thank you, Chris. Brilliant. Good morning, everybody. I just -- I had to start by telling you about some rough math I did before I walked in today. And I believe this is my 70th earnings call. It's also going to be my last. I'm very grateful to the analysts and investors who are part of this journey with me. Many of you help me better understand the perspective of our shareholders, which influenced how we ran the company, how we developed our strategies and priorities, and how we communicated about our results and plans for the future. I always try to ensure that the senior leaders in the company understood your views and perspectives, and they understood who they were really working for. Some of you have been at this work almost as long as I have, and your commitment to understanding our company and its potential has been remarkable. I just want you to know that it meant a lot to me. I'm very proud to have served as the CEO for this company for 10 years, as a senior executive for more than 20 years. It was an honor and a privilege. This company stands for more than its products and technology, its revenue or its earnings, and even its performance for customers all over the world. The people that work here are exceptional humans, not just exceptional workers. That's why this transition was so important to me. It is perhaps the most important work of my entire career. And I have a smile a mile wide today because of the quality of the individual that replaces me and the strength of the team beneath her. Jennifer Rumsey is a once in a generation leader. She combines the leadership and technical skills needed, with the characters and values required and the inspiration of a CEO that can take this company to places where I could not. I'm as proud as I was on the day I took the job to see her succeed me. Jen?

Thank you, Tom. Good morning. I'm excited to join you this morning in this new capacity as President and CEO for Cummins. In July, we announced that Tom would end his term as CEO effective August 1. It is a bittersweet moment for me as he's been one of the most significant influences in my career and leadership. Tom has been an incredible leader for this company and a true partner and coach to me. Because of his leadership, we are in a strong position to navigate what comes next and execute our Destination Zero strategy. Tom and I share a common vision for Cummins and the role that our company plays empowering a more prosperous world. I feel deeply honored and proud to serve as the new CEO of Cummins, the first woman and just the seventh CEO of this great company. My life and leadership have prepared me for this role at this moment during the critical period for Cummins and our planet. A focus on purpose, people and impact has shaped my career and will influence how I lead. I look forward to working with all of you as we move forward. I'll start with a summary of our second quarter financial results. Then I will discuss our sales and end market trends by region. And I will finish with a discussion of our outlook for 2022. Mark will then take you through more details of both our second quarter financial performance and our forecast for the year. Before getting into the detail on our performance, I wanted to take a moment to highlight a few major events from the second quarter. The company achieved significant milestones related to 2 previously announced acquisitions: Jacobs Vehicle Systems, or JVS, and Meritor. In April, Cummins completed the acquisition of…

Thank you, Jen, and good morning, everyone. We delivered strong results in the second quarter, especially in the context of a challenging global business environment. As Jen mentioned, our second quarter results included a $47 million benefit from adjusting the reserves related to the suspension of our operations in Russia and $29 million of costs related to the separation of the Filtration business. To provide clarity on operational performance, I'm going to exclude the impact of these items in my comments. We have provided a breakdown of the costs associated with Russia and the filtration separation costs by line item and by segment in our earnings material to help you understand the underlying performance more clearly. Now let me go into more details on the second quarter performance. Second quarter revenues of $6.6 billion were up 8% from a year ago. Sales in North America were up 15%, while international revenues declined by 2% due to a sharp slowdown in China. Foreign currency fluctuations, primarily a stronger U.S. dollar, reduced sales by 1%. EBITDA was $1 billion or 15.7% of sales for the quarter compared to $974 million or 15.9% a year ago. The lower EBITDA percent was driven primarily by negative other income and lower joint venture earnings in China. Gross margins improved year-over-year and from the first quarter. Now let me go into more detail by line item. Gross margin of $1.7 billion or 25.6% of sales increased by $208 million or 140 basis points. The benefits of stronger volumes and higher pricing more than offset higher freight and material costs for this quarter. Of course, we have been facing increased costs for an extended period of time. And now our gross margins have returned back to 2019 of pre-COVID levels. Selling, admin and research expenses increased by…

Thank you, Mark. [Operator Instructions]. Operator, we're ready for our first question.

[Operator Instructions]. Our first question is from Jerry Revich with Goldman Sachs.

Tom and Jen, congratulations.

Thanks, Jerry.

So Tom, over those 70 earnings calls, I just want to add some rough math, too. So the earnings power of Cummins is up about sevenfold. So congratulations to you and the team here.

Thank you, Jerry.

I'm wondering if you could just talk about the supply chain environment. You folks are sending a lot more via airfreight than you do in a normal environment. I'm wondering if you could just flesh that out for us. What proportion of your shipments are now airfreight versus in a normal environment? And how should we think about, whenever demand does slow, what decremental margins might look like given the step down that we see in expedited freight in that environment?

Great. Thanks, Jerry. Yes, we continue to experience an environment where supply chain is limiting our production in most of our markets. And as you've seen, the team here has worked really hard to navigate that and continue to deliver as much product as we can to our customers who are also experiencing issues. Some of those issues have lessened. We continue however to experience constraints, in particular, in the electronics space, microprocessors and other electronic components. We've seen improvement in our premium freight and also are closely monitoring what's going on with the standard freight rates. So while we have some improvement off the peak, we're still running at high levels as we continue to navigate disruptions caused by a combination of supply constraints and COVID-related disruptions.

I was just going to ask you if it's possible to quantify how much higher than is the normal?

Well, at one point, last year, we were running probably 4x the normal level of premium freight, and that's come down. It has been that we've seen sequential improvement over the last 3 or 4 quarters, but we're still running 2x to 3x kind of extra costs right now. And then you'd asked about decremental margins, Jerry, in the event there's a slowdown. What I would say to you is we have to embrace these cycles when they come. We have a very experienced team that's navigated through several of them. I'm very proud of our record of raising cycle-over-cycle performance at the peak and trough. I can't give you exact decremental margins, but know that we will adjust plan outcome to operate the wells to continue to as and when the next cycle comes. That's all I can say really at this point.

Got it. And just lastly, normally, your margins tend to be down in the third quarter versus second quarter seasonally. I'm wondering given the supply chain, the dynamic that we have here, could we actually see margins flat up for you folks sequentially depending on how supply chain performs?

I think the biggest challenge in the second half -- well, it's baked into our guidance, is that we see a drop-off in earnings in China. We typically see about a 25% to 30% lower JV income in the second half of the year, and we're projecting that again. You've heard from some of our important customers what their trajectory looks like on the top line going into the third quarter. Yes, there's still a lot of moving parts, still a lot of challenges we're working through. We've maintained our full year guidance. We're slightly behind the EBITDA percent for the full year through the first half of the year, but we're on track, not expecting extraordinary variation, at least from what we know today.

Our next question is from Tim Thein with Citigroup.

Yes. Tom and Jen, congrats to you both. Yes. And Tom, I trust you'll be dialing into that 71st call, just so you can hear Chris read through the legal disclaimer.

No question about it.

Yes. So yes, Tom, maybe one for you, just higher level. Obviously, you've observed a number of cycles during your time. And I'm just curious, you mentioned that you guys weren't seeing anything of note. But obviously, there's a lot of broader concerns regarding the potential for either a recession is here or on our doorstep. And I'm just curious, if you have conversations with customers, what would you be alerting the team for in terms of signposts or indications of -- if that begins to, in fact, come through, where would you be watching? And what kind of, again, signals would you be kind of leading the team for?

Thanks, Tim. And I have been through a lot of these, and this is an unusual one, there's no question about it. But I'm going to flip it back to Jen just because in terms of conversations with customers about where they are, Jen's actually been doing more of those than I have. But I would say that -- I just kind of repeat the point Mark made. It is an unusual period and it has been an unusual cycle. And I think our team has continued to figure out ways to adapt to it, and I think we will here too. But make no mistake, a lot of us in the industry are trying to figure things out that we haven't faced before, labor shortages, part shortages over extended periods and things like that, I think you've heard from Jen. But let me just turn it back to her for kind of your perspective, Jen, of the customers and what they're looking at.

Yes. Great, great. Thanks, Tom. As Mark and Tom have said, we're in a cyclical business. We have a strong team that understands how to navigate and manage over the cycles and use the cycles to strengthen the business and emerge stronger. And this is not a typical cycle because, coming out of the COVID-19 -- early part of COVID-19 pandemic, we have seen really strong demand that has been constrained by supply chain constraints across the industry. And we have been unable to meet our collective customer demand in these markets outside of China. That have been strong now for 18 months. You see that showing up in very high aftermarket demand as well as customers have been using these products heavily and had higher parts demand as they worked to keep them running. So despite the fact that we do see some decrease in spot rates, some reduction off of really high indicators, when I talk to customers and look at some of these backlogs and freight activity, it's still very strong. And they still would like us to supply more than we're able to. So the conversations are all focused on where are we at with supply constraints and can we ship more to them. We continue to monitor those overall indicators. At this point, end customer demand is strong. Aftermarket demand is strong. Used truck prices continue to be elevated. And also recall, with higher fuel prices, these more fuel-efficient, next-generation products are attractive to customers. And so we'll continue to stay close to it and monitor what happens. But right now, we see supply being the constraint through this year outside of China.

Our next question is with Jamie Cook with Credit Crédit Suisse.

Congrats, Jennifer. And congrats, Tom, and thank you for all the support throughout the years. I wish you well. And I'm sure you're going to miss all our very insightful questions on earnings calls. I guess, Jennifer, my first question for you, understanding that you and Tom have been working closely together, and you co the Destination Zero strategy. You both obviously worked closely with and have buy-in. But sort of every CEO puts their own sort of stamp on a company. So just sort of -- as you're thinking about leading the company, sort of maybe nuances or differences relative to Tom or how you're thinking about the company just slightly differently? And then I guess just my second question, and I'll -- Jennifer, this is for you or for Mark. It's probably unfair, but I'll ask it anyway. Understanding you can't control a downturn if we have one, but I feel like Cummins' downturn theoretically in 2023 could be different as you think about, one, we have -- we're adding Meritor, you have market share wins. I guess we won't have the Filtration business. And maybe China is actually okay in this downturn because we're still -- the markets are depressed. So any way you want to sort of put buckets around how that could be additive to a normal downturn? Sorry for an unfair first question, Jennifer.

Thank you, Jamie. Appreciate the question. And as you noted, Tom and I have developed the Destination Zero strategy together. I've been a member of the Cummins leadership team now for more than 7 years as Chief Technical Officer, leading the Components business, Chief Operating Officer, and now CEO. So the strategy, the focus of the company going forward remains the same. The commitment to all of our stakeholders to deliver strong results, to really create strategic advantage to our people will continue. I think the big difference is just that, as we continue to operate in this evolving environment, paying attention to how markets are evolving, technologies are evolving, integration of Meritor, major new company, I'm going to be thinking a lot about strategic execution, and what does that mean for different parts of our business as our strategy evolves and paying attention to a more dynamic environment. And that's one of the reasons why I've kept the President role in addition to CEO is to stay close to the businesses as we focus not only on continuing to refine that strategy, but really driving strategic execution and delivering results. As it relates to next year, we'll, of course, talk later more about next year. You've heard us say we see supply being the limiting factor through this year. Backlog is strong. China is down, and will improve, right? There's a lot of opportunity to improve. And Cummins is very well positioned. Our products are performing very well. The customer demand for that product is strong. We have new partnership opportunities in the core business and in New Power. And we'll continue to invest in products that will position the company for the future and manage through the cycles as they come.

And by the way, I'll miss you, Jamie.

No. I mean, that's fine. I was just wondering, too, I mean, the incremental market brings more opportunities and also the Meritor, some of these market share wins start to help in 2023? If you want to answer, fine, if not, that's fine. I can get back in queue.

I think you just described most of my work plan from Tom, we'll be working on all of those. Thank you.

Our next question is from Steven Fisher with UBS.

Not sure if I missed this, but what was your first half aftermarket growth? I know you raised the full year of 15% to 20% from 15%. Just kind of wondering what you're assuming for kind of the second half trajectory within that guidance if some of the market activity is kind of slowing that down at all?

Yes. Steve, it's Chris. Yes, we experienced about that same level in the first half, and we expect it to hold throughout the year. I think the demand is still very high, particularly in the heavy-duty market, in North America as well as the global Power Systems markets. Mining, oil and gas have strong demands there for aftermarket parts, rebuilds and whatnot. So we expect that to hold certainly through the remainder of 2022.

Yes. Q2 was a little stronger than Q1. As Tom and Jen mentioned, there have been some supply chain challenges. So these are little bit, and demand remains strong.

Okay. And then as you're kind of discussing with Tim before, I mean, it seems like we're kind of in this broad macro limbo at the moment. I guess I'm just curious how that is affecting any of your investment plans or strategic actions, if that's changing the timing of anything?

Yes. Good question. So obviously, we've moved forward with our JBS acquisition and Meritor will complete this week. We're continuing to make these key investments in the future. And we are still in the process on the separation of our Filtration business as we've disclosed previously and monitoring the environment as that continues.

And the other thing I'd add is, we're just -- as you'd imagine, we're not just waiting around for changing economic conditions. An important part of how we've grown the earnings over time is just like a continual focus on trying to drive efficiencies in everything that we do. Doesn't always make the headlines, but almost every aspect of our work, we're looking for efficiency, better output. So we're always looking for those types of ways to improve the underlying performance of the business.

Our next question is from Rob Wertheimer with Melius Research.

Congrats to both of you. My question is really on New Power. There's a lot that's changed in the world in the last 6 months. Your revenue trends are pretty good. And I'm curious if you have any comments on competitive position within electrolyzers, whether you see it solidifying or expanding. You guys have the wherewithal to invest, and presumably, that pays off somehow. And then just whether the outlook into, I guess, '23, '24, I'm not sure how far along your backlog extends is inflecting upwards as the world reevaluate its energy mix?

Yes, yes. Great question. So we did -- we delivered the highest revenue in the second quarter to date from our New Power business at $42 million and made a lot of progress across all parts of the business. So you saw announcements of new partnerships on fuel cells, both on and off-highway, where we think long term the market will move. Continuing to make progress and having lots of conversations on the electrolyzers and demonstrating the capability of our PEM electrolyzer solutions there. And we believe, as we demonstrate some of those larger installations of PEM electrolyzer, that the market's going to increasingly move towards that solution and that we're well positioned competitively. The market is lumpy at this point. And a lot of our focus is on building up capacity and scale to meet the demand. And so we will -- Amy and I will continue to be talking about what are those key milestones that we see in the market and in our scale-up activity and how that's evolving. We still feel very optimistic. And with this energy challenge that we see in the global world, expect that the focus and interest in green hydrogen will continue to grow. And lastly, with the Meritor acquisition, that's another key component that we think positions us well in the electric powertrain. And we'll be building on the business that we have and very complementary to our existing New Power business and electrified powertrain. So overall, well positioned for the future with New Power.

That's comprehensive answer. Any inside track on whether the Inflation Reduction Act gets passed? And then you would benefit obviously from green hydrogen with that. I don't know if there's any production or any other obvious benefits that you saw in that potential bill, and I will stop there.

Yes. Great. So we're hopeful that the Inflation Reduction Act will get passed. It has many key provisions that we think are important for advancing lower carbon solutions, and it fits well with our Destination Zero strategy. It's really critical that there's investment to build out infrastructure and to make these technologies more affordable as they scale in advance. So we are -- have been active and advocating for some of the key energy provisions in that act, and we'll continue to do that as our Congress considers it.

Our next question is from Matt Elkott with Cowen.

So after the initial COVID shutdowns in China, we saw a pretty record recovery in the remainder of 2020 and into 2021. I understand we're highly unlikely to see anything like that after the current lockdowns. But do you have any sense of how things could play out when or if China moves fully past lockdowns like most of the rest of the world has? And a longer picture question related to China as a follow-up. You've seen some western companies, like some automakers reconsider JVs in China. Do you guys still see your JV model in China as the right strategy? Any updated thoughts on that would be appreciated.

Yes. What happens with China COVID lockdowns is one of the big questions that we debate a lot. At this point, they continue to have this dynamic lockdown strategy. And we've continued to see some smaller scale lockdowns that have been happening and operating and kind of closed loop, closed circle environments within that from a business perspective. So I don't see when and how they completely evolve out of that. We're prepared to continue to operate in that type of environment. However, we do think that, that market is going to come back. It's a large market. It's an important market for us to be a part of because of its size. And we are committed to continuing to invest in the products and joint ventures that we have there, while also ensuring from a global supply chain perspective that we have resiliency in our supply chain so that we can navigate through COVID, weather disruptions and other constraints.

Our next question is from Noah Kaye with Oppenheimer.

And let me add to the congratulations here. And I just want to follow up on the IRA. So obviously, there's a lot of potential benefits for Cummins in this legislation. But among them, you could be looking at up to a $3 per kg production tax credit for green hydrogen. And obviously, it has been kind of on again, off again for the last couple of years. I have to imagine that some scenario planning has played out in some of these potential customer discussions. So at this point, is it possible to actually dimension the magnitude of the opportunities domestically that might pencil out with that kind of a PTC? And then how quickly do you think you can move to convert those opportunities to revenue if it does come to pass?

Yes. No. It's a great question. And within that, Inflation Reduction Act, as you noted, there is incentive for hydrogen production, which is significant, as well as incentives for other clean vehicles and clean fuels. It's important to note that there's also incentive for things like biodiesel and renewable natural gas within that. So a lot of things that will help drive advantage. We have had active conversations in recent years in Europe and growing conversations in the U.S. The Bipartisan Infrastructure bill also put some significant investment in hydrogen infrastructure. And so we believe that this will continue to add to that and are really focused on scaling up our product and production to meet the demand that we think will be there. So it's hard for me to mention specifically to you right now. As I said, we'll continue to talk about what we see as the key milestones in that business, growing revenue and growing our return from the electrolyzer business over time.

Okay. And maybe one quick follow-up, and there have been some discussions about preparing for a potential downturn and how you can flex down amidst that. But one variable that I'm sure you're considering is just the investment cycle for the next step-up in emissions reduction. So how do we think about that factoring into budgeting for next year, some potential increase, investment spending on the combustion side in preparing for tighter emission standards?

Yes. So you've seen us increasing our investments, in particular in both New Power and Engine business, as we invest in the technologies and electrolyzers in New Power and also these next-generation fuel-agnostic platforms and engine business. We have the scale advantage globally to do that. Those are investments that we will continue to make. And we're also looking at driving efficiency and improvement in parts of our business that can adjust with the cycle. And so we'll continue to deliver on our financial commitments and strong returns through the ups and downs as we invest in those key areas for our future.

Our next question is from Jeff Kauffman with Vertical Research Partners.

And like everybody else, Tom, thank you for your leadership, and Jennifer, best of luck in the future. I wanted to focus a little bit. You discussed supply chain costs and talked a little bit about what was going on with raw material costs. If we looked at the inflationary part of cost of goods sold, how do those costs stack up against each other, in terms of how much of the increase in expense is more on the raw input side versus how much more are we spending on supply chain than we normally would? And also noting that in recent weeks and months, supply chain costs while still high have been easing, raw material costs while still high have been easing. And I'm just kind of curious, is any of that built into the guide at this point, maintaining the margins where they are?

Yes. Jeff, this is Mark. So I would say, this year, if you look at our costs, the material costs have been increasing. That's been the biggest single driver on the costs side. Last year, certainly the first half of the year, it was very heavy on the freight -- premium-free costs. But then we started to see more inflation in materials play out over time. So as we talked about, the premium freight costs have come down a little bit, part of that through better coordination and management of the expenses. Material costs continue to increase at this point in time. We put the -- I would say, within a fairly predictable range quarter-to-quarter so far, yes, 1 or 2 commodity costs have come off the peak, but remain at fairly elevated levels. And of course, whatever changes there are in the market, costs of freight and metal markets, those take time to work through the supply chain.

Okay. But Mark, back to the question though. So for the quarter, costs of goods sold was up about 5% on total revenue growth of about 8%. Ex inflationary costs, what are we looking at in terms of that raw material or the costs of goods sold inflation? I'm just trying to understand how much is kind of temporary cost inflation on materials, how much is temporary cost inflation on supply chain costs and kind of what's the underlying rate?

Let me put it like this. Our material cost in the second quarter increased by 1.9% of sales year-over-year, just to -- what is temporary and what's -- we're always working to make changes to products, redesign things, take costs out. But right now, that's a pretty high level over what -- certainly pre-COVID, pre this inflationary environment, that there's a high level of material cost increases. What's temporary and permanent is very hard to say. But about 1.9%, freight costs are fairly flattish year-over-year, but at a very elevated level. Material cost increase -- there are some pressure on some of the categories, but those are the biggest elements.

All right. That's helpful. And then in terms of the guidance, I'm assuming no real change in either of those in terms of your outlook or has there been a change built into that outlook of margins maintaining?

No significant change on the costs side. We've lowered our outlook for JV earnings, which is not what you're talking about. But I'm just trying to triangulate back to the overall guidance of lower JV earnings. And we've got slightly stronger aftermarket revenues, particularly in North America, which should balance -- those balance out, but no significant changes on the other categories.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would now like to turn the call back over to Chris Clulow for closing remarks.

Great. Thanks, Maria. That concludes our teleconference for the day. Thank you all for participating and your continued interest. As always, the Investor Relations team will be available for questions after the call. Thanks.

You may disconnect your lines at this time. Thank you for your participation.