Greetings, ladies and gentlemen, and welcome to the Cummins Inc. Third Quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Jack Kienzler, Executive Director of Investor Relations. Thank you, sir. Please go ahead..

Thank you and good morning, everyone. Welcome to our teleconference today to discuss Cummins results for the Third Quarter of 2021. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger. Our President and Chief Executive Officer, Jen Rumsey, and Chief Financial Officer, Mark Smith.

We will all be available for your questions at the end of the conference. 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 this 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.

Due during the course of this call, we will be discussing certain non-GAAP financial measures and we 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 presentation are available on our website at www.

cummins.com, under the heading of Investors and Media. But with that out of the way, we will begin with our Chairman and CEO, Tom Linebarger..

Thank you, Jack and good morning. Welcome everybody. I'll start with a summary of our Third Quarter financial results and our market trends by region and finish with a discussion of our outlook for the rest of 2021. Mark will then take you through more details of both our third quarter financial performance and our forecast for this year.

Demand remains strong in the third quarter as the global economy continued to improve, driving strong sales growth across most businesses and regions outside of China. In China, industry-wide sales of trucks and construction equipment is slowed sharply, but in line with our expectations.

We remain encouraged by the economic trends in our markets, which point to strong end-user demand extending into 2022. We also continue to see orders for our products outpaced our competition as a result of their strong performance in the field.

Unfortunately, supply chain constraints continue to significantly impact our ability to produce and ship products, driving up costs and limiting sales growth in the short run. These supply chain constraints are impacting our OEM customers in much the same way.

Before getting further into our results, I want to take a moment to highlight a couple of strategic milestones in the evolution of our next-generation products and technologies. In October, we announced that we will bring a 15-liter natural gas engine for heavy-duty trucks to the North American market.

This engine was launched earlier this year in China and has been well-received in the market, demonstrating excellent performance and reliability this far.

The 15-liter natural gas engine is an important part of our path to zero emission strategy, by offering a significant reduction in both criteria pollutants and greenhouse gases in a product that's available today and utilizes existing infrastructure.

Equally exciting is that this engine is designed to accept a range of gases and renewable fuels, including hydrogen in the future. In fact, all of Cummins' engine platforms are being designed with the same fuel flexibility.

At the same time, we are working with Chevron and others in the energy industry to increase the availability of renewable natural gas and other renewable fuels to ensure infrastructure is in place to meet our customers needs.

We also signed a letter of intent to establish a joint venture between Rush Enterprises and Cummins, which will produce Cummins branded natural gas fuel delivery systems for the commercial vehicle market in North America, combining the strengths of momentum fuel technology's compressed natural gas fuel delivery systems and Cummins powertrain expertise along with the engineering and support infrastructure of both companies.

These are important steps in expanding our portfolio of Power Solutions options to help customers meet their business goals and operation objectives, while also meeting increasingly stringent emission standards and achieving our customers sustainability goals.

Now, I will comment on the overall Company performance for the third quarter of 2021 and cover some of our key markets. Revenues for the third quarter of 2021 were $6 billion, an increase of 17% compared to the third quarter of 2020. EBITDA was $862 million or 14.4% compared to $876 million or 17.1% a year ago.

Higher freight and logistics expenses, rising material costs and other manufacturing inefficiencies associated with the ongoing supply chain challenges in our industry. More than offset the benefits of global volume in increases compared to the third quarter of last year.

As a reminder, EBITDA in the third quarter of last year was helped by temporary salary reductions, which lowered our cost by approximately $90 million. Our third quarter revenues in North America grew 13% to $3.4 billion, driven by higher engine and component shipments across the heavy and medium-duty on highway markets.

Industry production of heavy-duty trucks in the third quarter was 55,000 units, increase of 10% from 2020 levels. Cummins sold 22,000 heavy-duty engines in the same period, up 30% from 2020 levels.

Industry production of medium-duty trucks was 26,000 units in the third quarter, a decrease of 5% from 2020 levels, while our Cummins unit sales were 23,000, an increase of 25% in 2020.

We shipped 43,000 engines to Stellantis for use in the RAM pickups in the third quarter of this year, a decrease of 2% from 2020 levels, but still a very strong quarter. Revenues for power generation grew by 2% due to higher demand in recreational vehicle, standby power, and datacenter markets.

Our international revenues increased by 22% in the third quarter of 2021 compared to a year ago. Third quarter revenues in China, including joint ventures, were $1.5 billion, a decrease of 11% due to lower demand in the medium and heavy-duty truck markets.

Industry demand for medium and heavy-duty trucks in China was 217,000 units, a decrease of 53% as the industry works through the national standard 5 truck inventory on hand and lower demand for newer higher-cost national standard 6 unit.

Our unit sales in units, including joint ventures, were 40,000, a decrease of 49% versus the third quarter last year. Our light-duty engine sales were 33,000, a decrease of 40% driven by supply chain constraints and weaker market demand. Industry demand for excavators in China in the third quarter were 56,000 units, a decrease of 15% from 2020 levels.

Our units in Cummins sold were 88,600 units, a decrease of 20%. Power generation sales in China increased 52% in the third quarter compared to a year ago, based on strong demand in data centers and other backup power applications.

We continue to hold a market-leading position in the data center segment in China, driven by strong end-user relationships and our compelling product offerings. Third quarter revenues in India, including joint ventures were $520 million, an increase of 76% from the third quarter of 2020.

Industry truck production increased by a 120%, while our shipments increased 135% as our joint venture partner continued to gain share. Demand for power generation and construction equipment also rebounded strongly in the third quarter compared to a very low base a year ago.

In our Power Systems market, industrial engine revenue increased 33% in the third quarter compared to the same period last year driven by mining in oil and gas. In Brazil, our revenues increased 26% driven by increased demand across all end markets. Now let me quickly cover our outlook for the remainder of 2021.

Based on our current forecast, we expect our revenue to be at the lower end of our guidance are up approximately 20% versus 2020. EBITDA is now expected to be approximately 15%, below our previous guidance of 15.5% to 16% of sales.

Our expected EBITDA margins are lower because of the persistence of the supply chain constraints and disruptions, which are now exacerbated by escalating material and freight prices.

We've lowered our forecast for industry production of heavy-duty trucks in North America to 228,000 units, up 25% compared to 2020, but below our prior guidance of 264,000 units. This is again due to the supply chain constraints impacting our customers rather than a lack of end-user demand.

In the medium-duty trucks market, we are decreasing our forecast for industry production to a 118,000 units, up 15% year-over-year, but below our prior guidance of 134,000 units. We expect our engine shipments for pickup trucks in North America to be up 25% compared to 2020, an increase of 7.5% from our expectations three months ago.

In China, we continue to expect domestic on-highway demand to decline from record levels a year ago. Our 2021 outlook for medium and heavy-duty truck market demand is 1.65 million units, and our 2021 outlook for light-duty trucks market is 2 million units; both unchanged from our previous guidance.

We continue to expect industry sales of excavators to be flat with the record levels achieved in 2020 and unchanged from our previous guidance. In India, we anticipate industry demand for trucks to be up 75%,compared to levels experienced in 2020.

And our other businesses are showing promising growth due to continued infrastructure investment, this is also unchanged from previous guidance. We now expect demand for mining engines, to increase 60% in 2021. Up from our expectation of 45% 3 months ago based on continued strength in commodity prices.

We continue to expect global power generation revenue to increase 15%, primarily driven by the data-center and recreational vehicle markets. Summing up the quarter, strong demand across many of our markets drove continued sales growth in the third quarter.

Despite the strong demand, supply chain constraints continue to significantly impact both our operations and those of our customers, resulting in higher material and logistics costs, as well as capping revenue growth.

We are working collaboratively with our customers and suppliers to navigate these challenges and position the Company for better performance in 2022. Customers are recognizing the strong performance of our products, resulting in our sales growing faster than industry demand in a number of important markets.

We continue to invest in bringing new technology to our customers, outgrowing our end markets, and providing strong cash returns to our shareholders. The Company expects to return over 75% of our operating cash flow to shareholders in 2021 in the form of dividends and share repurchases.

Thank you for your time today and now let me turn it over to Mark..

Thank you, Tom and good morning everyone. There are four key takeaways from our third quarter results. End customer demand remains strong in the third quarter, driving sales growth -- strong sales growth across most end markets and businesses outside of China, where truck and construction demand has weakened in line with our expectations.

Global supply chains remain constrained, impacting our industry's ability to meet strong customer demand, and resulting in higher freight, labor, and logistics expenses and rising material costs.

As a result of the continued supply challenges and associated costs, we are lowering our full-year sales and profitability outlook even though underlying demand remains very strong.

Finally, we'll return $345 million to shareholders through cash dividends, and share repurchases in the quarter, and a total of $1.83 billion for the first 9 months of the year consistent with our plan to return 75% of operating cash flow to shareholders this year. Now let me go into more details on the third quarter.

Revenues were $6 billion, an increase of 17% from a year ago. Sales in North America grew 13% and international revenues rose 22%. EBITDA was $862 million dollars or 14.4% of sales for the quarter, compared to $876 million or 17.1% of sales a year ago.

As a reminder, EBITDA in Q3 last year would lose by $90 million of temporary salary reductions, and the $44 million VAT recovery in Brazil. Along with the strong demand, the key feature of our performance in Q3 was that our gross margin continues to be challenged by the supply chain constraints and elevated costs.

gross margin of $1.4 billion or 23.7% of sales increased by $65 million but declined as a percent of sales by 270 basis points. Global supply chain constraints continue to impact the industry's ability to meet elevated and the cost demand and have resulted in higher costs.

We incurred approximately $90 million of additional freight, labor and logistics costs in the third quarter. in addition to rising material costs, partially offset by increased pricing in the aftermarket.

SG&A expenses increased by $38 million or 7%, and research expenses increased by $42 million or 19% from a year ago, primarily due to higher compensation expenses. As a reminder, due to the significant uncertainty the onset of the COVID-19 pandemic, we implemented temporary salary reductions in April 2020, through the end of September last year.

These salary reductions resulted in approximately $90 million of pre -tax savings for the Company last year and impacted gross margin and our operating expenses and impacted the comparisons of the results of all of our operating segments.

Joint venture income was $94 million in the third quarter, down slightly from $98 million a year ago due primarily to weaker demand for both trucks and construction equipment in China. Other income of $32 million increased by $11 million year-over-year.

Net earnings for the quarter were $534 million or $3.69 per diluted share compared to $501 million or $3.36 per share from a year ago, primarily due to a lower tax rate and a reduced share count. The effective tax rate in the quarter was 19.9%. Our income tax expense included favorable discrete items of $11 million or $0.08 per diluted share.

Operating cash flow in the quarter was an inflow of $569 million dollars compared to $1.2 billion dollars a year ago. An increase in working capital led to the lower operating cash flow for this quarter. Now, let me comment on segment performance and our latest guidance for the full-year 2021.

For the engine segment, third quarter revenues increased 22% from a year ago, driven by increased demand for trucks in the U.S. and construction equipment in the U.S. and Europe.

EBITDA decreased from 18.1% to 15.2%, primarily driven by higher supply chain costs, lower joint venture income, and higher compensation expense, partially offset by the benefits of stronger volumes and lower warranty expense. But the full year, we've reduced our revenue guidance to be 24% at the midpoint, down 1% for the full year.

We now expect EBITDA margins to be between 14.2% and 14.7% a little below our prior year guidance of 14.5% to 15% primarily due to the weaker sales on ongoing supply chain challenges. In the distribution segment, revenues increased 14% from a year ago.

EBITDA increased in dollars but decreased as a percent of sales from 10.6% to 9.8% primarily due to some of the supply chain challenges but again the higher compensation costs. We have maintained our 2021 outlook for distribution segment revenues to be up 8% and increased EBITDA margins to 9.3% of sales at the midpoint of our guidance.

Component segment, revenues increased 16% in the third quarter, driven primarily by stronger demand for trucks in North America. EBITDA decreased from 16.9% to 14.1% primarily due to higher supply chain costs and higher warranty expenses compared to very, very low cost of quality in the year-ago quarter.

For the full year, we now expect components revenue to increase 28%, lower than our prior guidance of up 32%, primarily driven by a weaker outlook in North America and slightly lower outlook for China truck.

We have also lowered our forecast EBITDA margins for the segment to be at 15.5% of sales at the midpoint, down from our prior guidance of 17%, as this segment is being more hardly -- has been hit harder by the supply chain challenges and the slowdown in truck production in North America and China.

In the Power Systems segment, revenues increased 19% in the third quarter, driven by stronger demand for power generation and mining equipment. EBITDA increased by $33 million, and expanded by 10.3 to 11.5% of sales, primarily due to the benefits of higher volumes and lower product coverage expense. Partially offset by elevated supply chain costs.

For the full year we're increasing our power systems revenue guidance to be up 22% from our prior guide of 18% growth driven primarily by a stronger outlook in the mining segment. We're also increasing our EBITDA margin forecast to be 11.5% of sales at the midpoint from our prior guidance of 11.25.

In the new power segment, revenue increased $23 million, up 28% due to stronger sales of battery electric system. EBITDA losses for the quarter were $58 million as we continue to invest in new products and scale up ahead of widespread adoption of the new technologies that we're developing.

For the full year, we now project new power revenues of $120 million at the midpoint, and EBITDA losses to be in the range of $200 million. We expect total Company revenues now to grow approximately 20% at the low-end of our prior guidance.

We're also lowering our EBITDA margin guidance to be approximately 15% for the full year, down from our prior guidance of 15.5% to 16%. A slower pace of improvement in North American truck production and continued elevated costs associated with the global supply chain challenges were the primary drivers of the lower outlook.

We expect joint venture earnings to be up 10% for this year in line with our prior [Indiscernible]. We're forecasting our full-year effective tax rate to be 21.5%, excluding discrete items.

Capital expenditures were a $150 million in the quarter, up from a $116 million a year ago, when we continue to expect full-year capital spend of between $725-$775 million.

To summarize, we faced incredibly strong demand in many of our core markets but continue to face global supply chain challenges which have impacted our cost base, and more so than we'd expected in the second half of the year.

However, this end customer demand remains strong, outpacing supply in many important markets and setting us up for a strong 2022, assuming the global economy remains strong. I want to thank all of our employees for their tireless work this year to ensure that we've meet the needs of our customers while continuing to deliver solid financial results.

We continue to prioritize improving our performance cycle-over-cycle, investing in technologies that will power profitable growth and returning excess capital to shareholders. Thank you for your interest today. And now let me turn it back over to Jack..

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. And if you have any additional questions, please rejoin the queue. Operator, we are now ready for our first question..

Thank you. As a reminder, ladies and gentlemen, if you do have a question, [Operator Instructions]. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Again, [Operator Instructions].

And as just previously stated, please make sure you're limiting yourself to one question and one follow-up. Our next question is come -- sorry, our first question is coming from Stephen Volkmann of Jefferies. Please go ahead..

Hi, good morning. Thanks for taking the questions. Maybe I'll just dive in on some of these supply chain issues. Is it possible to just bucket the impact that you guys have seen? I'm thinking about price costs being a headwind, I'm thinking about logistics costs I think you gave us a number for that Mark.

I'm guessing there's probably some productivity headwinds. I'm just trying to see if we can better understand exactly what you're seeing relative to these supplier interruptions..

Happy to do that and good morning, Steve. So yes, we are almost 2% worse between the price we've recovered in -- well, not recovered. The price increases that we've made principally in the aftermarket this year, which has added about 70 basis points to our results.

And we've lost yeah, more than 2.5 points between the premium freight, rising material costs, and inefficiencies in our operations. And that's a little bit -- that's higher obviously than when anticipated 3 months ago.

We did see a reduction in premium freight from the second quarter to the third quarter, but we started to see more increase on the material cost side..

And Mark, is it too early? I mean, I'm assuming for 2022 year goal will be to get right with that. Or maybe even a little bit better.

I don't know, any commentary you can make as we go out into '22?.

I will just say this continues to be a high area of focus both on our operation side and also working through this with suppliers and customers and implementing price increases..

Hey Steve, this is Tom, the one thing that everybody is still worried about in our industry is semiconductors. It's not that things haven't improved some because they have, but it's marginal improvement. It's still a really tight supply chain, so there's a lot of issues across the supply chain, labor shortages, freight, etc.

But semiconductors look like they're -- they have a longer-term capacity issue and I'd also say the freight side of things just seems like it's not quite getting better yet when you look at where containers are and what ports look like.

So there's no question that, as Mark said, internally, we are working as much as we can to address our cost side inefficiencies. He talked about going out and negotiating price increases, and as you know on the material cost side, those come automatically, but we'll have to negotiate for the rest.

It's just that some of these things look like they are likely to be somewhat persistent. That doesn't mean we're not hoping to improve them all. I just want to be realistic about those. There'll be some element that looks like it goes into next year too..

Understood. Thank you, I guess high freight costs are probably good long-term for you guys, but we'll have to wait and see how that plays out. Thanks..

Yeah..

Thank you..

Thank you. Our next question is coming from Jamie Cook of Credit Suisse. Please go ahead..

Hi, good morning. I guess Tom, I just wanted to get more color from you on how you're thinking about China as we head into 2022, that's an important market for you.

And what, in terms of like the power shortages and outages over there, how that's impacting your business goals from a negative perspective and potentially a positive perspective over time. I -- so I guess I'll start there..

Yeah. Let me let Jen talk a little bit about how the China market is now and how we're seeing it, and I can jump back in and see us talk about sort of longer-term things..

Okay..

Hi, Jamie. As you heard from Mark, and we've been forecasting, we've seen a drop-off at the middle of the year in the China market -- on-highway market in particular, with the changeover between NS V and NS VI emission standards.

So we saw inventory building up in the first half of the year and we're now seeing that coming down and getting sold in regions that are still allowing NS V product sales. And so that combined with a higher cost of the new emissions product has, as we expected, driven a drop in on-highway demand, which we expect to come back to some degree.

2020 was a record year for China though, so our expectation is that market's going to come back to be more in line with what we saw in '19 for on-highway. We are benefiting in China from additional content in the components business with new emissions requirements and also the launch of the endurance transmission now in China.

So we see that benefit and we think our NS-VI products are going to performed well in the market as well and give us some upside potential. But the market overall is down. The construction market has also come down some and we are continuing to see some strength in the power gen market there.

We are watching the impact of those power shortage issues in China very closely with our suppliers, it's not created a major disruption for us to this point, but it is something we continue to watch closely..

Yeah. I would just pick up from where Jen left off, the power shortages as she said. Some impacts on production, but not a huge cost impact. But as you suggested, Jamie, we do think it helps us in the market.

And as I mentioned in my remarks, our power-gen business is positioned well in China and now I look at China and I see us positioned across all of our markets. The truck side, as Jen said, we've now got -- our automatic transmissions are taking off, our content across the engines is growing. There's more consolidation in the market.

So as things start to come back, I think we're better positioned we've ever been. Add to it, that we're now doing electrolyzers with a partner in China. We've got fuel-cell launches in China.

So on the new power side, while things are moving slower in China than maybe and people anticipated several years ago, that's just allowed us to position ourselves to be in those markets more strongly as they take off. So again, today -- looking where I am today, I'd say our position in China has really never been stronger. So, yeah.

Do I wish the market was stronger this year? Sure. But I think as it turns back down, we're able to consolidate more and strengthen our position..

And we have the new N15 natural gas product launched in China as well now, and that I think positions us better for what's a fairly sizable natural gas market in China as well..

Okay. Thank you. And then just as a follow-up, can you just talk to how far your order book extent today and to what degree there's risks that the order book has unfavorable pricing in it, and are you concerned about double ordering at all? Thanks..

Yeah. I mean, at this point, the demand out there is very strong. We're seeing growing back orders in some of our businesses.

And I've been out in recent couple of months talking with both OEMS and customers and there is strong demand out there that for sure is real at this point, customers are not getting all the trucks that they would like to get this year and do not believe even looking into next year, they think that there's going to be some limitations.

I think that orders are strong and as Tom said, we've got some contractual pricing on metals that we'll get, as we go into next year.

We've been taking pricing actions where we go direct to the market and aftermarket on PowerGen, and we're continuing to work with our OEM customers, on first-fit to negotiate pricing just in light of that cost environment we see right now..

Thank you very much..

Thanks Jamie..

Thank you. Our next question is coming from Ann Duignan of JP Morgan. Please go ahead..

Hi. Good morning. Thank you, Just to follow up on the supply chain, a quick follow-up, please. Would you expect, the announcement that we're eliminating the European tariffs on steel and aluminum to have any impact on U.S.

steel prices in 2022?.

Hi Ann I'm Tom, it's good to hear you. I really don't know because again, there are, as you know, export, I mean, sorry, import caps on that too. So how much that's going to really impact prices is unclear to me. And demand, of course, for metals is pretty high now. So the markets are pretty well-supported.

In fact, our mining, you saw our mining numbers are up and that's primarily driven by metal prices. So just in the U.S., it feels to me like it's going to have moderate long-term impact. Short-term, it may provide a little bit of relief, but I would have said that given the import caps, it's probably not a big move medium or long term..

Okay. Thank you. I appreciate the color on that and my real question though is more fundamental. I mean, you're talking about the 15-liter engine being able to use fuels like hydrogen as their major fuel.

If it's so easy to convert a 15-liter internal combustion engine to burning hydrogen, why are we investing in fuel-cells at all? If we can do it with just a new fuel injection system or some minor re-engineering of an internal combustion engine, why go down the path of the hydrogen investments or in particular fuel cells at all?.

Well, as you know, the hydrogen investments would be the same. Still we would need to generate hydrogen and, of course, we need green hydrogen in order to actually reduce the CO2 impact of the fuel. And really, hydrogen combustion is a good answer. It's just not as efficient as a fuel cell.

So if you're running our long-haul heavy-duty trucks where fuel is your number one cost or power energy is, then that efficiency increase from a fuel cell is going to be worth it to you.

If you have a relatively short range or you have a vocational truck, our view is maybe a hydrogen engine might work for you, especially if the conversion to fuel cell is too expensive and you're not having that many units.

So our view is there's a place for both, but if you want to think what's going to really drive the transportation economy 20 years -- 15 years from now, you're going to need the efficiency that a fuel cell, especially with an electric system, is going to provide.

So our feeling still as fuel sales win, for the majority of the trucking industry, but we -- hydrogen engines are a real addition to the portfolio of products that are -- can be available across our markets..

And there's a time factor too, as you can imagine. As fuel cells advanced and costs come down, and maybe there are period of time where hydrogen engines are having an economic advantage, but as Tom said over time costs come down, that efficiency benefit for customers that are really driven strictly by total costs on ownership.

May -- we think will drive a shift toward fuel cell and applications like Line Haul..

Okay, I'll take mine more engineering relented questions offline and then.

You have a lot of them. I'm going to be Jamie to be.

Ann [Indiscernible].

Ann, I'm going to be happy to have a longer conversation --.

I'm over-simplifying just simple fuel injection system re-engineering..

Exactly, I think taken 30 Second on it, we're designing this platform that the physical hardware for flexibility is exactly as you said, this fuel system and some other components differences and then the tuning.

Of course, the calibration and control of the engine is different based on the fuel, but we're able to leverage some of that manufacturing and engineering investment in a common platform..

Okay. Thank you. I'll get back in the queue. Appreciate that..

Thank you, Ann..

Thank you. Our next question is coming from Tim Tse of Citigroup. Please go ahead..

Thank you. Good morning. The question really is just hoping you could give some help in terms of how we should think about the relationship between heavy and medium-duty engine sales for Cummins versus Industry truck production, both in the fourth quarter and then as we get into '22.

I'm just thinking about how you out pacing the industry as your OEM customers deal with all these red-tag trucks. How should we think about that, again, relationship? Obviously, a global impact or maybe just thinking about the heavy-duty segment here in the near term..

Yes, there's a couple of dynamics. So of course, we've added some additional OEM customers. So when you think about our sales through OEMS and medium-duty and heavy-duty. And you saw -- you heard some of the numbers around how much of the total market we're seeing with Cummins engine.

So we feel really well-positioned, our products are performing well, there's a lot of end-user pull and we've seen good position in the market.

The dynamic that is happening in the fourth quarter, in most cases, we have been able to work through the supply constraints and continue to supply to our OEM customers and have not, in most cases, been the reason they've not been able to build trucks.

So as they take down some of their build rate, stabilize their production and complete these trucks that they build short of some components.

We have seen some reduction in demand on the engine itself as they're working to really stabilize and get to more efficient build rates to make sure they are building with what supply and inventory they have and level that out. So that is impacting that in the fourth quarter and in part why we adjusted our revenue guidance..

What I would add Tim is what we see is our products are performing incredibly well. We see it in our financials with very positive results on cost of quality and overall strong sense of enthusiasm for the products that we're putting in the market.

Invariably, you're going to get some volatility quarter-to-quarter, as we always do, but we feel really good about the position of our products in the market.

I think that's the message when you step back and when we're done with this year and and we look at the message you want you to leave with, and, of course, we're optimistic about picking up more business over time..

Got it. And then Mark just on the margin impact in components. Obviously, a lot of metals and platinum and palladium and etc. used there, and I know there's always a time lag.

Is there a way to think about the margin impact this year that's effectively a timing gap that you get the presume the -- presuming things stabilize, which maybe is a wrong assumption, but is there a way to think about what is more of a short-term impact that gets reversed next year or is it too hard to piece that part?.

If I just step back because there's a lot of noise year-over-year because some of the actions we took last year, the boosted results for us to step back from the noise of the numbers. I'll come back to that in a moment. Really, we're wrestling with three issues in that business that are somewhat different than we'd anticipated 3 or 6 months ago.

Number one, for the production in North America has not picked up in the second half of the year, if anything, it's drifted down a little bit. And we were counting on that in our guidance. So we think underlying demand supports are robust environment for next year, and that should take care of itself.

Number 2, whilst we anticipated a sharp drop in the second half of the year in China and that's playing out largely as we've expected. This business is doing a major product transition for NS-5 to NS-6.

And in variable when we start with the launch of new products, will below optimal scale, demand is still pretty light for NS-6 so as we ramp up, we'd expect margins to recover.

The bigger challenge, or the more, naughty challenges the rise in supply chain costs, which is really what we've seen when in the first half of the year we saw OEMS principally, availability impacting our operations, supply chain and the engine business. We've seen that spread more to more electrical components.

And what's happened is the components business has picked up more cost and efficiency. So that one's not you were working.

through all that. Yes, we got the metal costs, we got the normal contractual adjustments around that. But it's that focus on the supply chain and the other actions that we talked about at the start of the call that we're focused on here. But I just wanted to try and simplify the message. There's a lot of noise out there.

I'll just say one other thing just -- you didn't ask me, just clear up some noise I hear. Whilst -- in the explanations, we mentioned higher product coverage costs in this segment, it's compared to an extraordinarily low number last year. There's no big charge for product coverage or warranty in the segments.

I just wanted to clear that up for other listeners. Thank you..

Got it. All right. Thanks for the time, Mark..

Cheers, Tim. Yeah..

Thank you. Our next question is coming from Jerry Revich of Goldman Sachs. Please go ahead..

Yes. Hi. Good morning, everyone..

Hi, Jerry..

Hi, Jerry..

Tom, you folks target structural improvements in the business every cycle and I'm wondering as you look at the supply chain challenges that the entire industry face here, how are you folks thinking about potential changes in the way you manage inventories or the way you manage the supply chain going forward? Is there an opportunity to reduce some of the volatility by meaningfully increasing inventories given where cost of debt is, etc.? wondering how you're thinking about positioning comments coming out of this pretty complex environment we're facing here..

Jerry, it's a terrific question, and as you can imagine, it's been on my mind for a while. We did -- early in the pandemic we did do some structural reform. I think we talked about on some previous calls trying to say, hey, well, the market's down, let's make sure that we get our capacity rightsize and I think we did some good work early on on that.

But with the supply chain challenges, we've also seen a bunch of new problems that we weren't seeing before. You highlighted some of them. Do we have enough inventory in the right places? Are we outsourced in places we should be insourced? And then of course with trade challenges between countries, are we relying too much on cross-border trade.

So all those things now are in our strategy looking forward about how we want to reposition our supply chain. So today what we're doing is trying to get our costs down, trying to get our production up to meet customer demand, and trying to keep our supply chain people at work. when it's -- they're basically working 24/7.

It's been really, really rough, so I would just say that the strategic elements, while we're doing a lot of work and analysis on them, there's no question that we've taken a backseat to try to keep operations going in the last couple of quarters.

But those issues are first and foremost, for us and the leadership team, thinking about how we want to position.

And I will just say this, broadly speaking, what we're thinking about is we do need to reposition what we outsourced and what we in-source for the future, partly because of some of the supply chain challenges we've seen here, but also because the industry is likely to consolidate further.

And we need to make sure that we can be the reliable supplier that we need to be for our customers.

So we will be looking at that and thinking through where the right way to position ourselves in different supply chains is, but I think you've hit on a key point that there will be some optimization that will be helpful to us, both from a cost and reliability point-of-view overtime..

Terrific. On a separate note, I'm wondering if you could talk about the outlook for your electrification opportunities in off-highway markets, obviously a pretty fragmented supplier base in terms of other engine systems in the market now.

How do you see that as an opportunity set for comments and are there significant major new product milestones that we should look forward to as you folks electrify the off-highway offerings?.

As you said, off highway is more fragmented and generally speaking, conversations are a phase behind on highway in battery electric power trains, but they are common. As you'd guess, every major off highway producers trying to figure out what their long-term strategy is from carbon point of view and sustainability point of view.

We are having conversations with many of them. In all cases, I think the battery electric conversation, it is at a high level strategically as the same thing. All of them need a solution.

All of them want to figure out when is the costs -- the total cost of ownership for end-users work out and it generally doesn't today unless you're in a publicly financed application. If you're in a train or a bus or a ferry, okay.

If you're in a commercially viable thing, it doesn't quite work out yet, but the numbers as you know are changing quickly, but it still doesn't work out. So they are trying to figure out how to position themselves for when it does work out, who they partner with, and how.

And today, most of those partnership conversations are pushed out because there's not a viable offering to make today, nor is there a way to get to a viable offering within technologies and the costs as they are now. So everyone's looking forward trying to figure out what does it look like.

Off-highway, I believe, strategically, will be in the same challenge that they're in today. Not enough volume to justify a special one, but very specific needs to their application.

And our view is that Cummins will be well-positioned because we will have products and on-highway which will give us volume and scale and then we will have an understanding of their application and how to adapt the technologies most effectively to off-highway so that we'll represent a good partner to them, and as you guessed, that sort of the pitch I'm making to them now that we'd be the right partner for them in battery electric as we are with engines..

I appreciate the discussion. Thanks..

Thank you..

Thank you. Our next question is coming from Noah Kaye of Oppenheimer. Please go ahead..

Hi. Good morning. Thanks for taking the questions. Tom, I wonder if you could kind of update us on how the naturaliser pipeline is developing. I think we've seen some of the companies in the industry just a really robust demand growth since the start of the year.

And if you can also comment, obviously it's not set in stone, but there appear to be some pretty healthy incentives for nitrogen production in the reconciliational provision.

So just wondering if you'd comment on potential impact of that outgrow the business?.

Yeah. He thinks -- no I appreciate your question and the answer is, we have continued to see backlog growth in the electrolyzer business, and I'd say the big strategic move we wanted to make was to add some bigger projects to the backlog and those conversations have been going much better in a backlog.

I think last time we checked with 60 megawatts or something quite a good backlog, some newer larger projects which were exciting to add in there. And of course the problem with larger projects, they take longer to get together, and more likely delays in funding, but that's where the market's going.

We need to have those big ones, so it was good to see some of those come into backlog. and I would just say that the interest in electrolyzers is still quite strong. As you mentioned, the bill -- the Build Back Better Plan has some incentives in there for producing hydrogen, especially low -- carbon-free ammonia.

We think that's going to be a good use of electrolyzers in the early phase of electrolyzers. We see it in Europe where there's a carbon price already.

We see it in some fertilizer-related projects and it's an area where there's a lot of carbon used in fertilizer through gray hydrogen and making that hydrogen green is a way -- there's already demand calculations about how to get cost. Equivalency are pretty straightforward.

They're not easy, they take some funding and they take some incentives, which is why you see those in the bill. But once you do the calculations, you can see how you can get there, so I do expect that to be one of the markets that's likely to move more quickly, especially if those incentives make it through into law.

I do think it will promote the green hydrogen -- green nitrogen, I guess the green ammonia business pretty quickly in the U.S..

Thanks. And then just on a different topic, wonder if we could get any update on the filtration business, particularly in light of the comments made earlier about some of the operational changes or realignment from a high level that you're planning.

Where you at in terms of exploring the alternatives for that business?.

Hi Noah, this is Mark. Yes, we continue to make progress in pursuing the alternatives for that business. Our plans are unchanged and you should expect an update in the new year as we continue that work. Will be no -- I don't anticipate any significant change in the remaining three months.

But an update in the new year and the direction and the enthusiasm for that process remains unchecked. And I will just say the performance of that business has also been very strong this year that. It's embedded within the components business, but the business continues to do very well..

Yes. Thanks very much, Mark..

Thanks..

Thank you. Our next question is coming from Matt Elkott of Cowen. Please go ahead..

Good morning. Thank you. So guys, in the U.S., we're looking at significant upcycles in truck production as well as construction and mining equipment.

As these upcycles begin to unfold, are there opportunities for you guys to increase the percentage of your engines with your customers, both on-highway and off-highway? And if I take it a bit longer term, are there opportunities for potentially gaining new customers who may currently be fully integrated?.

Yeah, great question. We are constantly working to make sure that we have the most competitive engine in the market that drives end-user pull and grows our position in the market and also ensuring that we have capacity to meet OEM s' needs through strong cycles. And we continue to have conversations.

You've seen announcements around the partnerships with Isuzu, with Hino, with Dymo. We're continuing to have those conversations with customers that may not offer Cummins engines today to introduce those in the future. So we expect that those opportunities will continue over time..

So generally, during an OEM cyclical production up-cycle, does the vertical integration usually go up or down for the OEMS?.

Matt, it depends, but at the very top of the market, generally speaking, our penetration goes up a little bit because they run out of capacity if they use both, if they have both their own demand and ours.

But again, generally is not a good indicator for a given quarter and as Mark was saying earlier, quarter-to-quarter variation is pretty high because they may have backlogs. In this case, they may have unfinished trucks with more of their engine. So just quarter-to-quarter, it's hard to see.

What's more is because of the supply chain challenges, right now, OEM truck production is capped by suppliers. So we're not anywhere near the maximum production of the industry today. I mean, we hope to be based on what engine users demand, but we're not. We're in an area where they can produce more if they could get more parts.

So I think we're not really near the spot that you're asking about in terms of industry production..

Got it. Next [Indiscernible] Tom and then just one follow-up question on the natural gas engine. In the U.S. it's very small. I think it's -- you guys produce about 10,000 engines and you dominate the market.

With the 15-liter engine, can you talk about the growth opportunity and when you could see it unfold? I mean, is it going to be a meaningful opportunity next year or is this more longer-term?.

Yes. So the plan -- we've announced that we're bringing this N15 natural gas engine that we have in production in China now into the U.S. market by '24. So we're couple of years out from offering that product. As I've talked to end customers, they are very excited about this product and in particular, as they pursue their own goals for carbon reduction.

In the coming years, they see natural gas as a great way to meet those, including using renewable natural gas. So we expect some upside opportunities as we bring that new platform into the market and also some growing interest yo natural gas in the market..

Which again should boost our share given our position in natural gas, yeah..

Thank you very much..

Thank you..

Our next question is coming from Rob Wertheimer of Melius Research. Please go ahead..

Thank you. You guys touched on pricing earlier, could you remind us maybe just give a quick recap overview of how pricing works on engine platforms. Is that the only one where you have constraints on what price that includes material costs, escalators, but not freight maybe if I understand right.

And then, what portion of the mix do you then have to go after things like freight on?.

Broadly speaking, Rob, the way it works is that we have OEM long-term agreements with large customers for engines and the major components. That's the sort of sectors where you'll see some of those long-term agreements.

The benefit of those, of course, is that we can count on continued customer orders over a period of time over phase of production of trucks and engines. And the pricing arrangements in those for the most part, again, they're -- each one's a little different, but the general deal is it on basic material costs.

There's an escalator or a pass-through, and on the rest, you need to negotiate if you want to make a change. Doesn't mean you can't negotiate, just means you have to negotiate with your partner.

And then on generator sets and aftermarket where we go directly to retail customers, then we only have what's on the order book as what's what you can -- you can't price on. So as Mark and Jen said, we -- this year, we priced in the aftermarket. Early in the year, we priced in the aftermarket again.

In the middle of the year, and we always are looking back at that to see if we should do more. And then gen sets we also move pricing right away.

And then now what we're doing is talking with all of our OEM customers about the fact that we've had these escalators, not just freight, by the way, freight, logistics, material costs, special shipments as a result of delays in semiconductors, and other products that we want to recover from them, and we're in negotiations with them now..

Okay. That's helpful. And then, Tom, thinking about an overview on -- you touched on it earlier on semiconductors.

Do you have a sense on when you think the industry be in better shape and what does Cummins doing specifically I'd love your re-qualifying supplier, qualifying new suppliers, redesigning chips, etc, before the industry gets better? I'll stop there, thanks..

Yeah, I will comment on that one. So it's something we've been working really closely throughout the year and we've started to see some improvement quarter-over-quarter since the middle of the year and supply of microprocessors for most of our components that we've seen some growing disruption on other electrical components.

That has become a bigger issue for us in the second half of the year. And we have also in parallel been working and I think we'll revisit inventory strategies as we are able to build inventory. Not today in the current very constrained environment.

And we're also looking at, sourcing strategy and doing dual-sourcing back all the way to a tier 3 level to make sure we've got more flexibility in the future..

And Rob, the thing we really needed in the U.S of course, as we need, we need domestic semiconductor production that's targeted at the automotive industry.

That's -- I mean, that's -- I don't mean to be pie in the sky about it, but strategically, it's kind of a nightmare that we only have -- all those semiconductor wafers are coming from pretty much one factory or one set of factories in Taiwan, and that we're a very small part of that Company's output. That's not the ideal situation for a supply chain.

So if you ever said, hey, what's the strategic plan? The strategic plan has to be defined semiconductor manufacturers who think the automotive industry is more critical to their success and ideally to have some closer to shore onshore so that we can look at the total capacity and demand, because right now most automotive -- most trucks and buses are adding a significant portion of electronics.

Each revolution or each time that their new product ramps come out, they add 30% more chips or sensors or something, and that's not the way the industry semiconductor -- the capacity of the semiconductors is moving. So we need to add more capacity and we need to add it -- target it at those customers..

Thank you..

Thank you, Tom. And thank you, everybody. I believe that concludes our teleconference today. As always, thank you to everybody for your continued interest in Cummins and for joining today. I will be available for questions after the call. Thank you again..

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