Cummins Q3 2023 Earnings Call Transcript

Participants

Corporate Executives

• Todd Chirillo, Executive Director, Investor Relations
• Steph Disher, Chief Executive Officer
• Jack Kienzler, Chief Financial Officer

Analysts

• Tami Zakaria, JPMorgan Chase & Co.
• Joe O'Dea, Wells Fargo & Company
• Rob Mason, Robert W. Baird
• Jerry Revich, The Goldman Sachs Group, Inc.
• David Ridley-Lane, Bank of America Co.

Presentation

[Operator]

Good morning. My name is Krista, and I'll be your conference operator today.

At this time. I would like to welcome everyone to the Atmus Filtration Technologies Third Quarter 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session [Operator Instructions]

Thank you. I would now like to turn the conference over to Todd Chirillo, Head of Investor Relations. Todd, you may begin.

[Todd Chirillo, Executive Director, Investor Relations at Cummins]

Thank you, Krista. Good morning, everyone, and welcome to the Atmus Filtration Technologies third quarter 2023 earnings call. On the call today, we have Steph Disher, Chief Executive Officer; and Jack Kienzler, Chief Financial Officer.

Certain information presented today will be forward-looking and involve risks and uncertainties that could materially affect expected results. Please refer to our slides on our website for the disclosure of the risks that could affect our results and for a reconciliation of any non-GAAP measures referred to on our call. For additional information, please see our SEC filings in the Investor Relations pages available on our website at atmus.com.

Now, I'll turn the call over to Steph.

[Steph Disher, Chief Executive Officer at Cummins]

Thank you, Todd and good morning. It's great to be here with you today to provide an update on our third quarter financial results and business highlights for

Atmus. The Atmus team achieved another quarter of superior performance by focusing on our customers and delivering technology-leading Fleetguard products. I am pleased with the progress we have made to establish Atmus as an independent company.

We are a purpose-driven company and our culture is shaped by our shared values. We have a clear strategy, which is beginning to deliver results. Let me now turn to an overview of our performance in the quarter. First, I will review our global market and provide you with a summary of our solid third quarter. We continued to see strong demand in our first big market in the third quarter, and we expect this strength to continue through the end-of-the year. In the aftermarket, as expected, we continue to see softening conditions, driven by lower freight activity and continued destocking by customers. Most of our customers have now worked through destocking and we expect this impact to now moderate through the end-of-the year. In the China market, there continues to be a sluggish economic recovery from last year, which is likely to persist through the remainder of the year.

Now let's review our third quarter results. Sales in the third quarter 2023 was $396 million, a decrease of approximately 1% from the third quarter of 2022. Lower volumes were partially offset by higher pricing and FX tailwinds. Adjusted EBITDA margin rose 40 basis points from the prior year to 18.3%. We were able to grow margin on slightly lower sales as pricing actions along with improved commodity and freight costs, drove margin growth. EBITDA has been adjusted for one-time separation costs, which were $7 million in the third quarter of 2023 compared to $2 million a year-ago.

Adjusted earnings per share was $0.52. And adjusted free cash flow was $50 million. We have adjusted free cash flow for $2 million of one-time capital expenditures related to separation. Our performance in the third quarter has enabled us to fully repay our revolving credit facility during the quarter. Additionally, we are also raising our full-year 2023 guidance. Jack will provide additional detail later in the call.

As I reflect on our performance, it is clear our people provide the foundation for delivering these impressive results. During the quarter, launched our first leadership catalyst event. This event brought together our top 75 leaders to engage them in leading the Atmus way. This enabled us to engage key leaders in our purpose, culture and strategy. The same for the event, we're empowered learning and customer focus. The energy and excitement I felt from my engagement with this group of extraordinary leaders fuels my passion to unleash the full potential of Atmus.

As I have previously highlighted, our growth strategy is focused on four pillars. Grow share in first-fit in core markets. Accelerate profitable growth in the aftermarket. Transform our supply chain and expand into industrial filtration markets. Our products and technology leadership form the cornerstone for growth in our core first-fit and aftermarket segments. Our iconic Fleetguard brand is recognized in the industry as being synonymous with premium products. We have a unique multichannel path to market. Our global presence, provides us a diverse customer base across truck, bus, agriculture, construction, mining and power generation end market. With over 80% of our business being aftermarket, we are well-positioned to deliver strong results through the cycle.

Our filters are available in over 45,000 independent aftermarket retail outlets. We will continue to grow the retail presence of Fleetguard products with expanded partnership and improved availability. Our delivery metrics continue to rise, providing our customers the right product at the right time. I have been impressed by our team's ability to drive superior performance in product availability.

Achieving our growth and delivery targets will be fueled by the continued transformation of our supply chain. In addition to the Brazil and Mexico distribution facilities, we brought online earlier this year, we expect our Dallas facility to be operational in the fourth quarter. As we progress through 2024, we expect additional facilities to be operational across multiple locations in Europe and Asia-Pacific, providing us with a greater ability to enhance customer satisfaction. We also continue to evaluate a robust pipeline of opportunities aligned with our strategy for inorganic expansion into the industrial filtration markets. While we are enthusiastic to execute on this opportunity, we intend to pursue this growth through a disciplined programmatic approach. I will continue to update you on our progress.

This is an exciting time for Atmus and our customers. I am confident we have the right strategy to deliver superior results, and we have a strong and agile team who are demonstrating accelerated execution of our plant. Now I will turn the call over to Jack.

[Jack Kienzler, Chief Financial Officer at Cummins]

Thank you, Steph, and good morning, everybody. I will be discussing our third quarter 2023 results compared to the same period last year, and provide an update to our 2023 outlook.

As Steph mentioned at the beginning of the call, we delivered another quarter of solid financial performance. Sales were $396 million compared to $401 million from the same period last year, a decrease of approximately 1%. The decrease in sales was driven by lower volumes of $25 million, partially offset by $17 million of pricing benefits and $3 million of foreign exchange tailwinds. Gross margin for the quarter was $103 million, an increase of $3 million compared to the third quarter of 2022. In addition to favorable pricing, we saw commodities and freight improved by $16 million. This was partially offset by -- primarily by lower volumes and unfavorable manufacturing costs. Selling, administrative and research expenses were $52 million, an increase of $10 million over the same period in the prior year. The increase was primarily driven by administrative costs related to our separation and variable compensation.

Variable compensation is higher this year as our team continues to deliver impressive results in 2023. Equity, royalty and interest income was $8 million, an increase of $1 million from 2022. This resulted in an adjusted EBITDA of $73 million or 18.3%, compared to $72 million or 17.9% in the prior period. Adjusted EBITDA for the quarter excludes $7 million of onetime standalone costs. These onetime costs primarily relates to the establishment of functions previously co-mingled with Cummins, such as information technology, distribution centers and human resources function.

Our effective tax-rate for the third quarter was 23.1%, an increase of 110 basis points from the third quarter of 2022. The increase was primarily due to a change in the mix of earnings amongst tax jurisdictions, partially offset by a decrease in unfavorable discrete tax items. Adjusted earnings per share was $0.52. For the same period last year, adjusted EPS was $0.62. The decrease was primarily due to interest expense incurred as a result of the debt issued at our IPO. Adjusted free-cash flow was $50 million in this quarter compared to $42 million in the prior year. The improvement was a result of strong working capital management, partially offset by an increase in interest expense.

Now let's discuss our strong cash generation and liquidity position. Our ability to generate cash during the third quarter provided us with the opportunity to fully repay the $50 million borrowed on our revolving credit facility at the close of our IPO in late May. We now have full availability of $400 million under our credit facility. Combined with $139 million of cash, our liquidity at the end of the third quarter was $539 million. This liquidity provides us with flexibility to deploy capital for both our organic and inorganic strategic growth initiatives.

Now, I will provide an update to our guidance for the full-year 2023. With the combination of delivering another solid quarter and the increased visibility we have through the remainder of the year, we are raising our guidance as follows. We now expect sales to be in a range of $1.6 billion to $1.625 billion. We expect adjusted EBITDA margin in the range of 18% to 18.5%. This excludes an expected $30 million to $35 million of one-time separation costs for the full-year of 2023.

Moving to adjusted earnings per share, our outlook for 2023 is now in the range of $2.20 to $2.30. With the full repayment of our revolving credit facility, resulting in lower debt levels, we now expect interest expense to be approximately $25 million. Our effective cash tax-rate will be in the range of 23% to 25% for the full-year 2023. This range is consistent with our year-to-date average tax-rate. Overall, our team continues to deliver solid results during the third quarter, and we look-forward to achieving a strong full-year 2023.

Now we will take your questions.

Questions and Answers

[Operator]

[Operator Instructions] Your first question comes from the line of Tami Zakaria from JP Morgan. Please go ahead.

[Tami Zakaria, Analyst at JPMorgan Chase & Co.]

Hi, good morning and thank you so much and great quarter. So, my first question is, could you provide a little more color on the destocking headwinds you saw in, on versus off highway markets in the quarter and how you're thinking about those two for the remainder of the year?

[Steph Disher, Chief Executive Officer at Cummins]

Yeah thanks, Tami, and good morning. Let me just talk to the third quarter first and how we saw that playing out. And really we thought this in freight indices as well. We look significantly at the Cass Freight Index. September month was down 6% and I think year-on year and I think the quarter was down 9%. So from a demand perspective, we certainly saw a softer third quarter on the on-highway sector. And then we had the added factors of continued destocking with customers. As we've said throughout the year, we've seen our customers destocking at different, right? And some of that happened in the second quarter, some in the first quarter and then more significantly, we saw some in the third quarter. We think we're most of the way through that now, I would say. We see that moderating here into the fourth quarter. We still face headwinds from a demand perspective in our on-highway aftermarket. And so we'll see that come through in the fourth quarter, but so from a destocking perspective, we think we're largely through it in the on-highway side. It hasn't been as significant an impact on our results I would say in the off-highway side. Again I would describe it very similar, we think we're most of the way through the destocking and expect that to much more muted impact as we head into the final quarter of the year here.

[Tami Zakaria, Analyst at JPMorgan Chase & Co.]

Got it, thank you. That's very helpful. And my second question is, I remember you took some pricing in July this year. Any incremental pricing actions since then or expected in the rest of the year.

[Steph Disher, Chief Executive Officer at Cummins]

No, no incremental pricing actions. We did take them in July as you indicated and as Jack described in our bridge of the quarter, we saw some pricing impact offset the volume downturn.

[Tami Zakaria, Analyst at JPMorgan Chase & Co.]

Great. Thank you.

[Jack Kienzler, Chief Financial Officer at Cummins]

Thanks, Tami.

[Operator]

Your next question comes from the line of Joe O'Dea from Wells Fargo. Please go ahead.

[Joe O'Dea, Analyst at Wells Fargo & Company]

Hi, good morning. Thanks for taking my questions. I guess on that last topic and just in terms of some visibility to less destock headwinds is encouraging. Not sure about mix of price and volume in the fourth quarter, but it looks like based on revenue midpoint still looking at, maybe it's something like mid-single-digit volume declines. And if that's the case, just kind of the handoff from destock maybe to more macro and you can talk about does the freight environment get a little bit more challenging or anything else, just sequentially from 3Q to 4Q.

[Steph Disher, Chief Executive Officer at Cummins]

Yeah, thank you for the question, Joe, and good morning. So where I would describe the key market drivers for us and we've talked about this a fair bit but 80% of our business aftermarket, 20% first-fit, so I might just try and talk about those two cycles generically. So if I just start with aftermarket, we certainly saw a sequential increase in September over August in terms of freight activity. So whilst we say we're kind of at the bottom of the cycle in aftermarket, we still see continued declines year-on year, probably through sort of mid next year is how I would describe the aftermarket dynamics as we're seeing it. So still softer market conditions demand-driven in the fourth quarter. And so that's where we say we are in the cycle on the aftermarket side and mid single-digits as you described decline.

As we look at the first-fit, we're in a very strong position still in first-fit. Certainly see that continuing through the end of the year and we're more to the top of that cycle I would say and we say the two flipping throughout 2024 as I alluded to with aftermarket.

[Joe O'Dea, Analyst at Wells Fargo & Company]

Thank you. You framed that answer a lot better than I framed the question. That's all helpful. And then in terms of kind of strategic planning and as you're thinking about '24, any color on sort of where you are focusing top priorities and in particular around innovation spend and thinking about the verticals and the applications that you're particularly focused on as you plan out next year.

[Steph Disher, Chief Executive Officer at Cummins]

Yes, thank you. So as I talk about our strategy, I go right back to the four pillars of our strategy and head on driving that focus throughout our entire company. And so I'll talk to each of those in turn perhaps and reinforce the innovation component of your question. Firstly, we see ourselves in our first-fit market in our core business as leaders in fuel filtration technology and crankcase ventilation. We want to further enhance and grow our market share leadership in those sectors and we are investing specifically in programs and product development and innovating with our customers to secure greater share of those markets, is the first piece I would talk about as a priority investment for us, that's driving continued sort of R&D investment in the range of 2% to 3%, and we've got targeted capital expenditure that underpins and supports those programs for growth. So that would be the first in the core first-fit market.

If I talk about broadly, the other components of our strategy, accelerating profitable growth in the aftermarket, transforming in our supply chain and expanding into industrial filtration markets, I think your comments on innovation relate more to the fourth element -- fourth pillar of the strategy around expanding into industrial filtration market. We already have a very strong position in terms of our media technology capability and we want to leverage that technology capability across multiple horizontal end-markets and we are investing both capital and research and development investment to expand that innovative technology capability. That will be the largest one that I would point to there as a point of focus for us.

I might go just one step further on the industrial expansion strategy, we are very, very focused on how we're going to create value by aligning or acquiring companies that we can stitch together with our core capabilities and our technology and innovation is going to be fundamental to that creation of value.

[Joe O'Dea, Analyst at Wells Fargo & Company]

Very helpful details. Thank you.

[Operator]

Your next question comes from the line of Rob Mason from Baird. Please go ahead.

[Rob Mason, Analyst at Robert W. Baird]

Hi, good morning. I wanted to ask about your gross margin, it actually again outperformed my expectation. So -- and you noted some of the factors there. And I'm just curious now that if you think that is a more sustainable level around '26 versus obviously last year around '24 had some challenges, but I'm just curious how sustainability looks from here.

[Jack Kienzler, Chief Financial Officer at Cummins]

Good morning, Rob. This is Jack. I'll take that one. Yes, it's a great question. It's one we've been talking about a lot internally here, obviously there are some big moving factors year-on year as I think about gross margin, price, of course, being the biggest mover year-on year for us, which was offset by volume. We also had some positive tailwinds from a commodities and freight perspective. We are, I would say, quite focused on improving our efficiencies and taking costs out from a gross margin perspective and we will continue to focus on that moving forward. I think the biggest swing factors we do expect price to moderate certainly going forward off of what's been quite a volatile market call it 18 months span here, but I think a big factor will be what is -- what would input cost be moving forward. We've seen those cost moderate, which has been quite helpful. And we'll keep a close eye on those, all while continuing to drive efficiencies into next year in our manufacturing base.

[Rob Mason, Analyst at Robert W. Baird]

There was one mentioned in the discussion around your gross margin, Jack around unfavorable manufacturing. Is that -- was that different than volume in the quarter?

[Jack Kienzler, Chief Financial Officer at Cummins]

Yeah, so if I think about, call it our normal targeted decrementals, there was a bit more inefficiencies and that -- as we think about the cyclical aspects that Steph was highlighting, we're trying to make sure that we don't takeout too much fixed costs and not position ourselves to serve our customers in the aftermarket. So there was some inefficiencies. Obviously, there's a lot of work going on in our supply chain as we decouple that from Cummins that highlight a few of the warehouses that have been decoupled inside of Q3 and we're continuing down that journey. As you can imagine that that causes a lot of challenges, just operationally for our team that were continuing to you progress through and again try to focus on improvement moving forward. But that was a bit of a factor I would say in our gross margin performance.

[Rob Mason, Analyst at Robert W. Baird]

I see, very good. Thank you.

[Jack Kienzler, Chief Financial Officer at Cummins]

Thank you, Rob.

[Operator]

Your next question comes from the line of Jerry Revich from Goldman Sachs. Please go ahead.

[Jerry Revich, Analyst at The Goldman Sachs Group]

Yes, hi, good morning, everyone.

[Steph Disher, Chief Executive Officer at Cummins]

Good morning, Jerry.

[Jack Kienzler, Chief Financial Officer at Cummins]

Hey Jerry.

[Jerry Revich, Analyst at The Goldman Sachs Group]

I'm wondering if you could just talk about the implied fourth quarter margin guidance. You obviously performed really well year-to-date, you're guiding to roughly 50 basis points to 100 basis points of lower margin 4Q versus 3Q and I think the seasonality is more balanced than that, but maybe you can correct me if I'm wrong and just touch on the moving pieces 4Q versus 3Q. Is that just make sure we're on track that numbers, are there underlying headwinds that we should be thinking about sequentially beyond seasonality?

[Jack Kienzler, Chief Financial Officer at Cummins]

Yes, thanks for the question, Jerry. So I think it's really is all down to volume to be perfectly frank. Normally, we have seen a bit of seasonality but as Steph alluded to, it's more of a market dynamic that we're looking at in Q4, we do expect some softness to continue prticularly in the aftermarket as we move into that quarter and so that in terms of our normal decrementals coupled with some of the inefficiencies I was just commenting on to Rob is really the driver in that margin degradation that we're guiding to Q3 to Q4. Nothing really significant outside of that dynamic from a volume perspective.

[Jerry Revich, Analyst at The Goldman Sachs Group]

I appreciate it, Jack. And in terms of as we think about the performance this year, margins up and volumes down. How should we be thinking about operating leverage off of this space? Can we still get mid 20s incremental margins as volume come back. In other words, are we going to keep this price-cost gap that we built this year?

[Jack Kienzler, Chief Financial Officer at Cummins]

Yes, I can I can go ahead and start there. Certainly, we would expect to keep the price-cost gap, we don't have a history of pricing get backs in the aftermarket historically, and of course, we'll continue to monitor our cost base and take actions to recover that cost should increase, although that we will see based on where we sit today. Overall I do think obviously, we're continuing to focus on delivering the expected incremental margins in and around 20%. I think as we look to next year the big stories will be volume, right and then, we'll have a couple of tailwinds variable compensation, as I highlighted in my comments will be a tailwind. And so that coupled with some of our hopefully recovering markets and the aftermarket should present an attractive backdrop as we move into next year.

[Steph Disher, Chief Executive Officer at Cummins]

Yeah, and Jerry the only thing, I would add on the back of that. I've talked a lot about the supply chain transformation. Our focus on becoming more efficient delivering cost benefits in that area. We have kicked-off that program. We started to see some small benefits, not enough to even sort of make it to the commentary of our earnings right now. But we're going to build momentum around that, continue to underpin our focus on margin expansion. So that's the only other piece [indecipherable]

[Jerry Revich, Analyst at The Goldman Sachs Group]

That's clear. Thank you.

[Operator]

Your next question comes from the line of Andrew Obin from Bank of America. Please go ahead.

[David Ridley-Lane, Analyst at Bank of America]

Good morning, this is David Ridley-Lane on for Andrew Obin. Question on the sort of commodities and freight trend. What's embedded in your full-year EBITDA margin guidance for that in the fourth quarter?

[Jack Kienzler, Chief Financial Officer at Cummins]

Yes, sequentially versus Q3, we've seen some ups and downs as we move through the year. Obviously, overall it's been a favorable freight and commodity backdrop for us year-on year. We did see some sequential elevation of that as we entered into Q3. But all signs point to that I would say moderating. So essentially, as I alluded to it's really a volume story as we move into Q4, not expecting any significant swings from a freight and commodity standpoint.

[David Ridley-Lane, Analyst at Bank of America]

Got it, so it would be kind of neutral year-on year?

[Jack Kienzler, Chief Financial Officer at Cummins]

Q4 to -- yeah Q4 to Q4 of last year. Correct.

[David Ridley-Lane, Analyst at Bank of America]

Okay and then just sort of the change in the separation capex. It looks like about $10 million of projects kind of pushed out to next year, is that the right way to think about it?

[Jack Kienzler, Chief Financial Officer at Cummins]

Yes, so capex, it's really driven by timing of projects frankly. Most of those are IT programs that we're continuing to decouple from Cummins, which all coincide with different locations coming online. And so we have seen a little bit of a delay in some of that all for good reasons, but just a little bit of pushing those projects out into 2024. The overall amounts are still in line with what we've commented on, it's just a shift as we think about 2023 versus 2024.

[David Ridley-Lane, Analyst at Bank of America]

Got it and should we expect any unusual inventory build as you stand out these distribution centers? I'm just thinking on kind of do you need to fill them up before you start winding the others down.

[Steph Disher, Chief Executive Officer at Cummins]

Yeah, no, thank you, David, for the question. Actually we are the majority of the way through in terms of our large inventory sites in our distribution separation. So our distribution center in Kentucky is about 50% of our holdings. And so we already moved that at the beginning of this year, Mexico and Brazil, we've already moved across. So the sites we have last really lower inventory impacts sites, I would say overall. I'm not expecting a material impact to comment on, we certainly will manage the transition effectively that our customers are not impacted, but I don't expect it to -- I expect it to be managed inside a quarter and I really don't expect it to make these calls.

[David Ridley-Lane, Analyst at Bank of America]

Great, thank you very much.

[Jack Kienzler, Chief Financial Officer at Cummins]

Thank you, David.

[Operator]

We have no further questions in our queue at this time. I will turn the call back over to Todd for closing remarks.

[Todd Chirillo, Executive Director, Investor Relations at Cummins]

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

[Operator]

[Operator Closing Remarks]