Cummins - Q3 2023

Transcript

Operator (participant)

Greetings, and welcome to the Cummins Inc third quarter 2023 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. You may press star one at any time to enter the question queue. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chris Clulow, Vice President of Investor Relations. Thank you, Chris. You may begin.

Chris Clulow (VP of Investor Relations)

Great, thank you very much. Good morning, everyone, and welcome to our teleconference today to discuss Cummins' results for the third quarter of 2023. Participating with me today are Jennifer Rumsey, our Chair and Chief Executive Officer, and Mark Smith, our Chief Financial Officer. We will all be available to answer questions at the end of the teleconference. Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities and Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs, and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties.

More information regarding such risks and uncertainty 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 will 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'll turn you over to our Chair and CEO, Jennifer Rumsey, to kick us off.

Jennifer Rumsey (Chair and CEO)

Thank you, Chris, and good morning, everyone. I'll start with a summary of our third quarter financial results. Then I will discuss our sales and end market trends by region. I will finish with a discussion of our outlook for 2023. Mark will then take you through more details of both our third quarter financial performance and our forecast for the year. Before getting into the details of our performance, I'm excited to first highlight a few major events from the third quarter that demonstrate the continued execution of our strategy. On September 6th, Accelera by Cummins, Daimler Trucks and Bus, and PACCAR, along with EVE Energy, joined forces to accelerate and localize battery cell production and the battery cell supply chain in the United States.

The planned joint venture will manufacture battery cells for electric commercial vehicles and industrial applications, creating highly desirable manufacturing jobs in the United States in the growing clean technology sector. Total investment by the partners is expected to be in the range of $2 billion-$3 billion for the 21-GWh factory, with production expected to begin in 2027. We see this partnership as an opportunity to share investment with two long-standing partners while advancing a key technology solution for our customers and industry, and collectively, to accelerate the energy transition in the United States. In October, Cummins completed its acquisition of two Faurecia commercial vehicle manufacturing plants and their related activities, one in Columbus, Indiana, and one in Roermond, Netherlands. This acquisition is a natural addition to the Cummins Emissions Solutions business and will help ensure we meet current and future demand for low-emission products.

Lastly, Cummins announced several collaborations with our natural gas X15 engine that further enable our customers to achieve their decarbonization goals. Freightliner announced they are working with Cummins to offer the new X15N natural gas engine in its heavy-duty Freightliner Cascadia trucks. Also, Cummins and Knight Transportation, Inc announced that the industry's largest full truckload company has successfully tested Cummins' new X15N engine in Southern California, using renewable natural gas to realize reductions in nitrous oxides and greenhouse gas without compromising performance. The X15N, which will launch in North America in 2024, is the first natural gas engine to be designed specifically for the heavy-duty on-highway truck application. Now I will comment on the overall company performance for the third quarter of 2023 and cover some of our key markets, starting with North America, before moving on to our largest international markets.

Demand for our products continued to be strong across many of our key markets and regions. Revenues for the quarter were $8.4 billion, an increase of 15% compared to the third quarter of 2022, driven by the addition of Meritor and strong demand across most global markets. As a reminder, the third quarter of 2022 included two months of consolidated operations for Meritor, following the completion of the acquisition on August 3rd, 2022. EBITDA was $1.2 billion, or 14.6%, compared to $884 million, or 12.1%, a year ago. Third quarter 2023 results include $26 million of costs related to the separation of the filtration business.

This compares to third quarter 2022 results, which included $77 million of costs related to the acquisition, integration, and inventory valuation adjustments of Meritor and $16 million of costs related to the separation of the filtration business. Excluding those items, EBITDA percentage of 14.9% in the third quarter of 2023 represented an improvement from 13.3% we delivered in 2022, as the benefits of higher volume and pricing exceeded increased selling, administrative, research and development expenses and inflation costs. Third quarter of 2022 also included a one-time employee recognition bonus of $56 million. Research and development expense increased in the third quarter as we continued to invest in the products and technologies that will create advantages for us in the future, particularly in the Engine, Components, and Accelera segments.

In addition, operating cash flow for the third quarter of 2023 was a record inflow of $1.5 billion, compared to the $382 million in the third quarter of 2022, as we continue to focus on our working capital management within the business. I'm proud of our leaders and employees for their efforts in driving down costs and operational focus to achieve this record result for the quarter, and we will continue to focus on strong cash generation moving forward. Our third quarter revenues in North America grew 16% to $5.2 billion compared to last year, driven by the addition of Meritor and strong demand in our core markets.

Industry production of heavy-duty trucks in the third quarter was 74,000 units, up 1% from 2022 levels, while our heavy-duty unit sales were 29,000, up 18% from last year, reflecting strong demand for our products. Industry production of medium-duty trucks was 37,000 units in the third quarter of 2023, an increase of 7% from 2022 levels, while our unit sales were 32,000, up 19% from 2022. We shipped 41,000 engines to Stellantis for use in their Ram pickups in the third quarter of 2023, flat with 2022 levels. Engine sales to construction customers in North America decreased by 8%, driven primarily by high inventory in the channel. Revenues in North America Power Generation increased by 15%, as industrial and data center demand improved and supply constraints eased modestly.

Our international revenues increased by 13% in the third quarter of 2023 compared to a year ago, with the addition of Meritor and strong demand across most markets. Third quarter revenues in China, including joint ventures, were $1.6 billion, an increase of 24% as markets continued to recover compared to a very weak third quarter of 2022. Industry demand for medium and heavy-duty trucks in China was 243,000 units, an increase of 48% from last year. Our sales and units, including joint ventures, were 41,000, an increase of 36%. In light-duty markets in China, we saw an increase of 14% from 2022 levels at 442,000 units, while our units sold, including joint ventures, were 26,000, an increase of 12%.

Industry demand for excavators in the third quarter was 40,000 units, a decrease of 30% from 2022 levels. The decrease in market size is due to weaker activity in construction. Our units sold were 7,000 units, flat with 2022 levels, as increased penetration at new and existing customers offset the declining market. Sales of Power Generation equipment in China increased 5% in the third quarter, primarily driven by slight improvement in non-data center markets. Third quarter revenues in India, including joint ventures, were $730 million, an increase of 13% from the third quarter a year ago. Industry truck production increased by 17%, while our shipments increased 23%. Power Generation revenues decreased by 16% due to the second quarter pre-buy ahead of emissions regulation changes.

Now let me provide our outlook for 2023, including some comments on individual regions and end markets. Based on our current forecast, we are raising full-year 2023 revenue guidance to be up 18%-21% versus last year. We are also narrowing our EBITDA guidance range to be 15.2%-15.4%. We now expect higher full-year revenues in our component segment and higher profitability in our power system segment, offset by decreased profitability in our engine business as a result of softening aftermarket and off-highway markets. We are raising our forecast for heavy-duty trucks in North America to be 280,000-300,000 units in 2023 after a strong third quarter. Our current guidance forecasts lower industry truck production in the fourth quarter.

While orders remain relatively strong, inventory management, truck component shortages limiting our OEM production rates, and fewer working days are all contributing to our view for the quarter. In North America medium-duty truck market, we are maintaining full year 2023 market size guidance of 135,000-150,000 units, up 5%-15% from 2022. While we continue to work to increase our production through rebalancing across our global plants and improving the supply base, industry production continues to be limited due to other supply chain constraints. Consistent with our prior guidance, our engine shipments for pickup trucks in North America are expected to be 140,000-150,000 units in 2023. Volume levels in line with 2022.

Additionally, we maintain our guidance for North America construction to be down 10% to flat, driven by high channel inventory and softening market conditions. In China, we project total revenue, including joint ventures, to increase approximately 15% in 2023, driven by share growth, better volumes, and content increase. We project a 15%-25% improvement in heavy and medium-duty truck demand, and 10%-20% improvement in light-duty truck market coming off the low market levels in 2022, and that's consistent with the prior guidance. Despite the slow pace of recovery in the China truck market, we are continuing to see strong performance for the 15-liter natural gas engine, which we launched in 2021. Due to the expanding fuel cost differential, approximately 20% of the heavy-duty market is expected to be natural gas powered by the end of 2023.

In the short time since launching our new natural gas product in China, our share has been ramping up with strong customer reception in the heavy-duty market, and we expect momentum to continue into the fourth quarter. We look forward to launching the 15-liter natural gas engine in North America in 2024. We expect China construction volume to be flat to down 10%, in line with prior guidance, consistent with the tepid economy and weaker overall activity. In India, we project total revenue, including joint ventures, to be up approximately 6% in 2023, consistent with our prior forecast. We expect industry demand for trucks to be flat to up 5% for the year. We project our major global high horsepower markets to remain strong in 2023. Sales of mining engines are expected to be flat to up 10%, consistent with our prior guide.

Revenues in the global Power Generation markets are expected to increase 15%-20%, consistent with our prior guide, with the strong performance driven primarily by improvement in the data center and mission-critical markets. For Accelera, we expect full year sales to be $350 million-$400 million, and also maintain our EBITDA guidance of the expected loss of $420 million-$440 million for 2023. Within components, Cummins expects revenues contributed by the Meritor business for 2023 to be $4.7 billion-$4.9 billion, and EBITDA is expected to be in the range of 10.5%-11%. In summary, we are raising our guidance on sales of up 18%-21% and narrowing our EBITDA guidance range from 15.2%-15.4%.

Our guidance for the full year implies weaker revenue in the fourth quarter, while demand remains strong in several markets, softening in the aftermarket demand, a continued weak outlook in China, continued industry supply constraints impacting North America truck production, and inventory management efforts across many markets are some of the factors driving the lower fourth quarter run rate. In view of the lower forecasted revenues, we have initiated actions to reduce costs in our business, particularly in selling and administrative costs. In order to lower costs as we move into next year, we are offering voluntary retirement and a voluntary separation program in select regions and parts of our business for eligible exempt employees. We will continue to monitor our end markets closely and assess the need for further action while continuing to invest for our future.

During the quarter, we returned $238 million to shareholders in the form of dividends. Our long-term strategic goal is to return approximately 50% of operating cash flow to shareholders. The strong execution from the second quarter of 2023 continued into the third quarter, driving record operating cash flow despite the ongoing challenges in our operating environment. As we look forward to the opportunities ahead, we have a strong, capable leadership team who will help us successfully navigate an exciting and changing future. Today, I was also pleased to announce several promotions on my leadership team, which will be effective January 1st of next year. First, Srikanth Padmanabhan, currently Vice President and President of the Engine Business, will take on a newly created role of Executive Vice President and President of Operations.

In this role, Srikanth will lead important work that will define and drive improvements in how we operate as a company through the energy transition and ensure our success of our operational priorities. Throughout his more than 30 years at Cummins, Srikanth has worked across many of Cummins' businesses and regions and consistently pushed the boundaries of customer-focused innovation to position Cummins as a leading powertrain supplier of choice in the transition to a net zero future. Srikanth is a results and people-driven leader and is the perfect choice to lead this work. Second, Brett Merritt, currently Vice President of On-Highway Engine Business and Strategic Customer Relations, will assume the role of Vice President and President of the Engine Business, replacing Srikanth when he takes his new role. Brett has spent more than 25 years in the automotive and commercial vehicle industry, and more than 14 at Cummins.

The past eleven spent leading and growing the on-highway business from 800,000 engines in 2012 to 1.2 million engines last year. Brett is an experienced business leader and a trusted partner to many of our key customers, and I'm excited for Brett to lead this segment. Bonnie Fetch, currently Vice President of Global Supply Chain, will assume the role of Vice President and President of our Distribution business, replacing Tony Satterthwaite, who has been acting as interim Head of DBU. Bonnie, who previously led supply chain for DBU, has led the Cummins Global Supply Chain and Manufacturing organization, including Cummins new and recon parts business since early 2022, where she led her team in navigating the many complex supply chain challenges, as well as improved operational and functional performance.

Her more than 30 years of experience, including 20 years at Caterpillar before coming to Cummins, includes general management, HR, and supply chain leadership, and makes her uniquely qualified for this role. I'm excited for her to leverage her broad experience to run this segment. This is a period of change for our company, and it's also an exciting one. I want to end by thanking our Cummins employees who continue to work tirelessly to meet our customer needs and respond to the strong demand levels by ensuring quality products, strengthening our customer relationships, and navigating continued supply chain challenges. Our results reflect our focus on delivering strong operating performance, investing in future growth, and bringing sustainable solutions to decarbonize our industry, while returning cash to shareholders. Now, let me turn it over to Mark.

Mark Smith (CFO)

Thank you, Jen, and good morning, everyone. Third quarter revenues were $8.4 billion, up 15% from a year ago. Sales in North America increased 16%, and international revenues grew 13%. Organic sales growth was 10%, driven by improved pricing and strong demand for our on-highway and Power Generation products. 5% of the total increase in sales was driven by the addition of Meritor. EBITDA was $1.2 billion, or 14.6% of sales for the quarter, including $26 million of costs associated with the planned separation of Atmus.

EBITDA in the third quarter of 2022 was $884 million, or 12.1% of sales, including $16 million of costs associated with the planned separation of Atmus, and $77 million of acquisition, integration, and inventory valuation adjustments related to the acquisition of Meritor. Excluding the Atmus separation costs and Meritor adjustments, underlying EBITDA in the third quarter was 14.9% compared to 13.3% a year ago. The higher EBITDA percentage was driven by favorable pricing to recover rising input costs and improved logistics costs, partially offset by higher variable compensation associated with the stronger overall company financial performance. In addition, we issued a one-time employee recognition bonus in the third quarter of last year, totaling $56 million.

To provide clarity on operational performance in comparison to our guidance, I'm excluding costs associated with the planned separation of Atmus and the acquisition, integration, and inventory valuation adjustments related to the acquisition of Meritor in my following comments. As a reminder, we completed the acquisition of Meritor in August of 2022, resulting in one additional month of operational performance in Q3 this year compared to last year. Now I'll go into more detail by line item. Gross margin for the quarter was $2.1 billion, or 24.6% of sales, compared to $1.7 billion or 22.9% last year. Gross margin increased by 170 basis points, driven by favorable pricing and logistics costs and the impact of the one-time employee bonus last year, partially offset by higher variable compensation expenses.

Selling, admin, and research expenses were $1.2 billion or 14.1% of sales, compared to $997 million or 13.6%, with the increase primarily driven by both higher variable compensation and higher engineering costs associated with new products across the company. Income from joint ventures was $118 million, $48 million higher than the previous year, driven by the receipt of technology fees and slowly improving demand in China, which boosted the operational results. Other income was -$7 million or $20 million lower than a year ago, driven by foreign currency translation. Also included in other income was $28 million of mark-to-market losses on investments. Interest expense increased by $36 million, primarily due to higher interest rates on the floating rate portion of our debt.

The all-in effective tax rate in the third quarter was 21.4%, including $5 million or $0.03 per diluted share of favorable discrete items. All-in net earnings for the quarter was $656 million or $4.59 per diluted share, including $26 million or $0.14 per diluted share of costs associated with the separation of Atmus. All-in net earnings in the third quarter of last year were $400 million or $2.82 per diluted share, which included $16 million of costs associated with the planned separation of Atmus, and $77 million of acquisition and integration costs associated with the acquisition of Meritor.

All-in operating cash flow was a record quarterly inflow of $1.5 billion, $1.1 billion higher than last year, driven by solid earnings and continued focus on working capital management. Generating strong operating cash flow remains a key focus area for the company, and we were pleased with the progress in the third quarter. I will now comment on segment performance and our guidance for 2023. As a reminder, 2023 guidance includes a full year of operations for Meritor and Atmus and excludes any costs or benefits related to the separation of Atmus. Guidance also excludes the impact of any cost reduction activities within Cummins in the fourth quarter.

As Jen mentioned, we are raising our revenue guidance for the company to up 18%-21%, up slightly from our prior previous guidance of up 15%-20%, driven by strong demand in North America. EBITDA is now expected to be 15.2%-15.4% compared to our previous range of 15%-15.7%. We are also narrowing the EBITDA ranges for most of our business segments. Component segment revenue is $3.2 billion, an increase of 20%. EBITDA was 14.2%. That was the prior year, while EBITDA dollars increased from $394 million to $461 million. Meritor, Cummins Meritor revenues in the third quarter were $1.2 billion, and EBITDA was $129 million, or 11% of sales.

A significant improvement from last year and in line with our expectations. For the component segment, we now expect total 2023 revenues to increase 35%-40%, a 3% increase from our previous revenue guidance, with EBITDA in the range of 14.2%-14.7%, compared to our previous range of 14.1%-14.8%. Within components, Meritor revenues are expected to be $4.7 billion-$4.9 billion, consistent with prior guidance, and EBITDA loss is expected to be in the range of 10.5%-11%, compared to our previous forecast of 10.3%-11%. Lots of small changes in the individual segment guidance as we get closer to the end of the year.

For the engine segment, third quarter revenues were $2.9 billion, an increase of 5% from a year ago. EBITDA was 13.5% compared to 13% in 2022, driven by operational improvements and the impact of the one-time employee bonus in the prior year. In 2023, we project revenues for the engine business will increase 2%-7%, consistent with our prior projection, and EBITDA in the range of 13.6%-14.1%. A slight decrease from our previous guide of 13.8%-14.5%, due to a continuing softening in aftermarket revenues, and some weaker demand in some off-highway markets. In the distribution segment, revenues were $2.5 billion, 13% higher than last year.

EBITDA increased as a percent of sales to 12.1%, compared to 10.7% of sales a year ago, driven by stronger volumes, improved pricing, and the impact of the one-time employee bonus last year. We expect distribution revenues to be up 10%-15%, consistent with prior guidance, and narrowing the expected EBITDA range to 11.9%-12.4%. In the power systems business, revenues were $1.4 billion, an increase of 7%, and EBITDA increased from 14.3% to 16.2%, continuing a trend over the last six quarters of improving margins driven by pricing, higher volumes, operational improvements, and cost reduction activities have all contributed to the continuing improving performance.

In 2023, we expect revenues to be up 8%-13%, consistent with the prior guidance, and we're raising the expected EBITDA to be in the range of 14.8%-15.3%, up from our previous projection of 14.3%-15%. Accelera revenues more than doubled to $103 million, driven by electrolyzer project delivery, higher demand for battery electric systems in the North America school bus market, and the addition of the Siemens commercial vehicle business electric powertrain portion of the Meritor business. Our EBITDA loss in the segment was $114 million, as we continue to invest to support strong future growth.

Our guidance for the top line and the bottom line for Accelera remains unchanged, with revenues in the range of $350 million-$400 million and net losses of $420 million-$440 million. Our effective tax rate for the year is expected to be approximately 22% in 2023, excluding any discrete items. Our outlook for capital investments is unchanged and expected to be in the range of 1.2%-1.6%. We will continue to focus on deploying cash to fund investments that drive profitable growth, debt reduction, and returning cash to shareholders through dividend this year. In summary, we delivered strong sales and solid profitability in the third quarter and record operating cash flow.

We'll continue to focus on managing working capital, delivering strong margins, and investing in the products and technologies that will drive future growth. As we indicated last quarter, we see signs of softening aftermarket demand and weaker demand in some industrial markets. These factors, combined with less production days in the fourth quarter, are expected to contribute to lower revenues and profitability. We have initiated some steps to lower costs, as Jennifer outlined, and will continue to monitor our end markets closely and assess the need for further actions. Our priorities in 2023 for capital allocation, as I've said, are to reinvest for growth, increase the dividend, and reduce debt.

In July, we announced a 7% increase in the dividend, our 14th consecutive year of quarterly dividend growth, and through the end of the third quarter, we have reduced debt by $390 million. Furthermore, in October, we reduced debt by a further $650 million, consistent with our plans for the year. Thank you for your interest today. Now, let me turn it back over to Chris.

Chris Clulow (VP of Investor Relations)

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

Operator (participant)

Thank you. Our first question is from Jerry Revich with Goldman Sachs. Please proceed with your question.

Jerry Revich (Senior investment leader and Head of U.S. Machinery, Infrastructure, and Sustainable Tech franchise)

Yes. Hi. Good morning, everyone.

Chris Clulow (VP of Investor Relations)

Hey, Jerry.

Jerry Revich (Senior investment leader and Head of U.S. Machinery, Infrastructure, and Sustainable Tech franchise)

Jennifer, congratulations on the joint venture with PACCAR and Daimler. You know, as we look forward to what that means for Cummins' product availability and offering within EVs, can we just expand on that in terms of what's the opportunity to bundle it with e-axles, battery management systems? And, you know, if you could just talk about, is there a plan to use the plant to source batteries globally for your customers? Or is this strictly focused on the U.S. initially? Just would love your broader comments. Thank you.

Jennifer Rumsey (Chair and CEO)

Yes. Yeah, sure, Jerry. I'll add a little bit more, color to what we're doing with this, this partnership. As I said, this partnership is really focused on battery cell manufacturing. So we have previously, been investing and focusing on battery packs, e-axles, motor inverters, so other key components and integrated power, powertrains for the electrified powertrain, and together with our partners, saw the need to bring, production of battery cells into the U.S. and really design what we think is gonna be a winning, cell solution for commercial vehicles and industrial applications. So this will be supplied into the battery packs that Cummins will produce. The cell will also go, to, to PACCAR and to Daimler Trucks here in North America for their battery cells.

Really is targeted at the U.S. market, and having a domestic offering that we think will really lead the market. And the chemistry here for this, we will continue to offer battery packs around the world and chemistries, including LFP and NMC, but this one is focused on LFP technology, which, again, together, we think is gonna be a winning commercial vehicle battery cell chemistry, lower cost, better durability, less dependency on some of these minerals that can be harder to source, and also improved safety. So really good opportunity for us and also to stay you know, stay closely connected with those two partners as we're launching these electrified powertrains. Our intent is to offer that battery cell through our packs to other commercial vehicle and industrial applications here in the U.S. as well.

Jerry Revich (Senior investment leader and Head of U.S. Machinery, Infrastructure, and Sustainable Tech franchise)

Okay. Super. And, Mark, can I ask just a shorter-term question on the engine segment? You folks had pretty solid performance in the quarter and for the year. You know, the reduced margin rate at the midpoint seems like a big step down in profitability implied fourth quarter versus third quarter. Can you just talk about, is that a significant production cut, China JV, or is that just, you know, it taking the midpoint of the range versus, you know, with the, thinking about the broader, maybe higher end potential outcomes?

Mark Smith (CFO)

Yeah, I think it's not related to China. It is related to the fact that we're gonna have less production days. That's consistent with the industry forecast for lower heavy-duty truck, which isn't a surprise, but that's what we've kind of been projecting for a couple of quarters. The thing that's really changed through the course of the year, Jerry, is the decline in the aftermarket, particularly that's running through the engine business. No doubt some of that's related to customers rationalizing inventory. I think the underlying rate of decline is less than the headline rate because we've gone from a period of everybody trying to keep up with demand, and now, like ourselves, many companies are looking at inventory levels and trying to right size.

But just to give you a sense, within the engine business, between the first quarter of 2023 and the fourth quarter, parts revenues are down about 18%. So that's kind of been slipping each time we've looked at it. So that's the one changing trend. I don't think it's foretelling doom. I just think it's mostly inventory adjustments, but that combined with the lower production days, the lower absorption, means that yes, even though the revenues are holding up for the fourth quarter, it's gonna be a little bit tougher.

And you know, and that's one of the reasons, not the only reason, why we've decided to initiate the actions that were discussed earlier. We're not predicting like a precipitous decline in our revenues at all. We don't have a visibility, but clearly, there's a leveling off or a slight decline in some areas, and we feel it's prudent both to do the cost reduction actions, continue our focus on cash flow and debt reduction here. That should leave us with, you know, the best chances of being very successful in 2024.

Chris Clulow (VP of Investor Relations)

One quick, Jerry. It doesn't change our overall guide for engine business, but it is a difference between Q3 and Q4, is our JV income does step down because of license fees timing. So we had a lot of that happening in the third quarter. That steps down about 40 basis points for engine business margin from Q3 to Q4. So that hopefully that helps.

Operator (participant)

Thank you. Our next question is from David Raso with Evercore. Please proceed with your question.

David Raso (Senior Managing Director, Partner and Head of the Industrials and Machinery Research Team)

Hi, thank you. I'm curious, the cost out decisions, how much is that related to what you're seeing on the horizon in 2024? And if you can give us any insight on what that is. And maybe margins in 2023 being maybe a little more of a, let's say, a heavier lift to expand margins than maybe we see across the machinery space broadly. Just curious, how much is it sort of structural to what, you know, how 2023 is playing out versus what you're seeing in 2024? And obviously, any sense of magnitude of the cost outs would be really helpful. Thank you.

Jennifer Rumsey (Chair and CEO)

Yeah, David, I'll start and then Mark can add if he wants to add anything. So, you know, as we said, we see that, you know, many of our markets have leveled off. We're seeing some drifting down in some of the markets, aftermarket, off-highway. And, you know, what we are continuing to focus on ongoing improvement and profitability and performance of our business and using softening markets as a further opportunity to take costs out.

So we still see a lot of strength as we go into next year. We're not gonna provide guidance for 2024. Today, what I will say is, you know, if you look at backlog and heavy-duty truck and medium-duty truck continues to look quite strong as you go into the first half of the year. Power Generation is very strong, and so we're not seeing any precipitous drop off, but we think it's wise to take some cost-cutting actions here in Q4 and then continue to monitor the situation. If we need to take further action, of course, we would continue to do that.

Mark Smith (CFO)

We'll give you a fuller assessment on the next quarterly earnings call about both the cost and the benefit impact. Of course, what we're announcing today is voluntary action, so we don't know what the exact take-up is gonna be, and then our assessment of what is the kind of momentum in markets going forwards. There will be some other smaller actions around facilities and other things, but we'll lay that out in detail in the next quarter when we've got a more holistic or clear, hopefully clear review of the full year next year.

David Raso (Senior Managing Director, Partner and Head of the Industrials and Machinery Research Team)

That's helpful. Maybe you can educate me on something. I'm a little confused by the comment in the fourth quarter engine margin. And I appreciate Chris's comment about the JV income, how that all impacted 3Q to 4Q. But you highlighted a lower parts impact, you know, benefit in the fourth quarter.

Mark Smith (CFO)

Yeah.

David Raso (Senior Managing Director, Partner and Head of the Industrials and Machinery Research Team)

Then when I see the Components business, which obviously has a lot of parts as well, it seems like you're implying a strong fourth quarter on margins for components. So can you educate me on why the difference one division is getting hit on parts and really the parts division, you would think for aftermarket, even more so, components, is having a step up in margins in the fourth quarter? At least that appears to be applied.

Mark Smith (CFO)

Well, the size of the parts business in the engine business is significantly bigger than the size of the aftermarket business in the components.

David Raso (Senior Managing Director, Partner and Head of the Industrials and Machinery Research Team)

But the difference is one good step down and one step up. And maybe I'm just doing the math wrong but it seems like the component implied fourth quarter margin's pretty strong.

Mark Smith (CFO)

Yeah, I think it's pretty stable. I think, that's just the dynamics we're seeing between the two different businesses right now.

Jennifer Rumsey (Chair and CEO)

Both of those segments are anticipating lower production volumes for North America, medium and heavy-duty truck market in Q4, for the reasons that I outlined. There, you know, frankly, there's a combination of focus on inventory reduction and supply constraints that are continuing to prevent OEMs from building to the full demand, and we expect to see that in Q4 impact our revenues for both of those segments.

David Raso (Senior Managing Director, Partner and Head of the Industrials and Machinery Research Team)

All right. Thank you very much.

Mark Smith (CFO)

Yeah, there can be some differing customer demand for components and engines in any given short-term period, David. That's. I think you're right, in the longer run or medium, over multiple quarters, they should correlate pretty well. But in this case, we're seeing a bit more pressure on the parts on the engine side. It's not all parts that are sourced directly from our Components business. That's the main point.

David Raso (Senior Managing Director, Partner and Head of the Industrials and Machinery Research Team)

All right. Thank you.

Mark Smith (CFO)

Thanks, David.

Operator (participant)

Thank you. Our next question is from Rob Wertheimer with Melius Research. Please proceed with your question.

Rob Wertheimer (Founding Partner and Machinery Analyst)

Hey, I had two. One, is just on the, the parts destock that you've mentioned, and that makes sense. I'm just curious if you have any sense as to how much channel inventory people carry, if you're all the way through that, half the way through, if you just quantify that potential, if you're able to.

Mark Smith (CFO)

It's a little hard to say. I would say what we tend to see more clearly on the power system side is destocking almost every year into the fourth quarter. We are seeing some of that and some lower rebuilds, particularly in the slice of the oil and gas market that we supply, Rob. But I would say the engine, on the engine side, the on-highway side, there may seems to have been a more sustained multi-quarter approach. And I think part of that, you know, there was a focus on prioritizing OEM new builds, first fit builds, as we started to ramp up through this cycle and wrestle through supply chain. And then the parts was in catch-up mode, and now we're finding, you know, truck utilization has leveled off. Everybody's trying to do a better job on the inventory management.

It feels like it's, you know, we're getting towards the bottom of that right now. Of course, that always depends on what's the economic environment and what's the underlying level of, you know, truck utilization. So if you were to ask me today, do I think we're on a clear trend to have significantly lower parts in Q1? I'd say no. So it feels like this is, you know, the strongest step has been in the last three quarters with the information that we have right now.

Rob Wertheimer (Founding Partner and Machinery Analyst)

Perfect. And then if I can ask kind of a bigger picture question in China, it's obviously been very weak for a lot of industrials. Maybe it's bottomed in all your end markets, maybe in some. I wonder if you could just give just your high-level view of what's going on in the economy there, whether fleet dynamics mean you kind of have to be in recovery mode, whether that's true of trucks or, or power gen, or just maybe give an overview of China, what you see in different parts of your business on the, you know, on the recovery. Thank you.

Jennifer Rumsey (Chair and CEO)

Yeah. So when we look at the China market, I mean, overall economic activity has continued to be pretty weak there. We've seen improvements in 2023 compared to 2022, when they were heavily impacted by COVID lockdowns and, you know, even more extreme weakness. So you've seen some improvement. You know, we've seen the strong demand for natural gas, heavy duty engines because of the cost delta between natural gas and diesel there. We've kind of come through the emissions changeover in the on-highway market. And so if we see recovery and continued recovery in the economy there, I think that will continue to positively impact our business. And with the product investments that we've made, the emissions change, you know, we'll have more content and we think continuing to increase our penetration. So we'll watch and see if any of the government stimulus does start to drive positive momentum and the economic activity. But it's been relatively weak this year.

Mark Smith (CFO)

Yeah, I mean, just to give you, I know we don't like talking about months, but July was, like, the lowest in a decade, right, in some of our JV production. It's crept up since there, but it has been tough. Again, it's not worse than we thought, but that just gives you a sense of how weak it was in the summer. Hopefully, there's upside from here, but we don't have good visibility to that.

Chris Clulow (VP of Investor Relations)

Yeah, the 1 billion RMB bond that's planned, I think that's encouraging to see the government moving. That won't impact the fourth quarter, but hopefully it somehow drives some more infrastructure growth in the next year. We'll wait and see, though, Rob.

Operator (participant)

Thank you. Our next question is from Tami Zakaria with JPMorgan. Please proceed with your question.

Tami Zakaria (Executive Director)

Hi, good morning. Thank you so much. So I just wanted to ask about the Power Systems business. Margins came out really strong, sales growth strong as well. But when we look at the fourth quarter guide, it seems like you're guiding to a step down of almost 200 basis points sequentially. So just wanted to get a sense of what's driving that. Is this conservatism or is there something that we need to be aware of for the fourth quarter for the segment?

Mark Smith (CFO)

Right. So the good news is they've been performing really well, so that's the underlying. I think we expect that to be a continuing trend. As I mentioned earlier, typically we see, particularly with the industrial side of that business, that the customers really drop down their purchase of parts in the fourth quarter. That's not new, but that's typically happens every Q4, and that's probably the main negative factor. Otherwise, the underlying demand is strong. There's no major changes to pricing or the cost structure.

Tami Zakaria (Executive Director)

Got it. That's very helpful. The next question is R&D spend. R&D spend over the last five years have stepped up notably. How should we think about that spend that's in the next couple of years? And any color on that?

Jennifer Rumsey (Chair and CEO)

Yeah, Tami, you know, we are, as you noted, in a period of increased R&D investment that we think will position Cummins well for the future. So in particular, you know, now through the 2026-2027 timeframe, when we launch these new fuel agnostic engine platforms, we're making major R&D and capital investments, and those are bringing new customer business to us and also will position us to have leading products through the energy transition. We've also been increasing our investment in the Accelera business as we ramp up the product investments for our electrolyzers and see growing demand for electrolyzer volume as well as in the electrified component. So that's really what you're seeing come through in the R&D line. And then we're continuing to really focus on improving underlying performance and efficiency in other areas so that we can continue to make the necessary R&D investments.

Mark Smith (CFO)

Yeah, and that's why we've had a big push on the SG&A and continue to do that so that we, well, and gross margins, so we can grow margins, grow investment, grow the bottom line, and keep improving the cash. That's a simple formulae that we're working to, and I'm glad to see the cash flow come up. The engineering is going to remain at these higher levels for a little while yet. And it's also, you know, the new engine business platforms are contributing to the, yeah, CapEx being higher in dollar terms. It's in our expected ranges of percent of sales, but for the next couple of years, we've got these renewal of these major platforms, which is important for our future.

Operator (participant)

Thank you. Our next question is from Tim Thein with Citi. Please proceed with your question.

Tim Thein (Analyst)

Thanks. Good morning. The first question is on Power Systems, and I'm just curious about kind of the visibility that you have looking into 2024. And, you know, backlog isn't something that we, you know, historically really talked about with Cummins, but, you know, just given that the long lead times for large engines and just visibility you have from a rebuild perspective, can you just maybe speak to where you think you exit the year in terms of, again, I know you're not giving 2024 guidance, but just any sort of help you can give in terms of what kind of revenue visibility you would expect to exit the year with in that business?

Mark Smith (CFO)

Yeah, you're right, Tim, that there's more visibility, both long lead times and the underlying demand. Certainly, I think we've got great visibility through the first half of the year. And of course, you know, we're anticipating more pressure on the on-highway side, just because it's not a severe downturn, but, you know, generally, market participants are expecting some moderation in heavy duty truck orders going into next year. So we would expect, you know, more revenue headwinds on the engines and component side. Distribution, as you know, is fairly heavily aftermarket driven, so absent some massive crash in the economy, that should be more stable. And then power systems, certainly very strong visibility through the first half of the year and some into the second half of the year. We haven't seen a dramatic shift in trajectory at this point in time.

Jennifer Rumsey (Chair and CEO)

Yeah, I mean, we're continuing to, as Mark said, to watch the power systems markets and in the industrial markets, we have seen a little bit of softening in oil and gas, which is, you know, relatively small market for us that kind of goes and fits and bursts. And so that, you know, that has softened a little bit. And then in power gen, you know, you see a lot of growth this year and, you know, I expect continued strong demand in the data center market for our business, and we're well positioned there.

Mark Smith (CFO)

It's encouraging that both Power Systems and Distribution now are on multi-period margin expansion trends, so that, that serve us well going forward.

Tim Thein (Analyst)

Yeah. Okay. And then, just, you know, a lot of discussion here in terms of the on-highway parts business for you. And, you know, and again, I know it's probably a bit of apples and oranges, but, you know, just listening to the commentary from your largest customer and kind of the outlook there they have for their own parts business, what do you think, again, I know you don't want to speak for them, but what do you think is the, you know, you mentioned down 18%, I think, from the beginning of the year. I think they're down, like, 2% or 3%. What do you think is driving that variability between, you know, your Cummins experience versus at least some of the OEMs?

And yet I know that the businesses don't align perfectly, but presumably, you know, they're impacted by a lot of the same dynamics. Just curious on your view on that.

Mark Smith (CFO)

Generally, I think it's destocking, right? We've, you know, we have obviously we know returns levels and things like that from, you know, all parts of our channel have gone up as customers have been de-

Jennifer Rumsey (Chair and CEO)

Yeah, I think it's really important to note, you know, through this cycle, two very different dynamics because of the supply constraints than what you would previously see. So the aftermarket demand was really strong, and with the supply constraints, it was challenging for some of our customers to get parts. And so there was a lot of focus on building up inventory to try to buffer against those constraints and a focus, frankly, on addressing the gaps that resulted in an overbuild of inventory.

So now that some of those supply challenges have eased, this getting inventory back to appropriate levels has been a focus, and that's driven a drop-off beyond just the aftermarket demand in service. Then, you know, the same is true and happening on the first fit build, that we've had supply constraints that have limited our ability to meet industry demand, and you see that resulting in the markets holding up longer than you would typically see and continuing to see solid demand for first fit trucks.

Mark Smith (CFO)

And then if I just step back from the noise in this kind of correction period, Tim, clearly our market share in North America on highway markets has gone up noticeably, so that should all go well for the parts that will inevitably be purchased through Cummins. I just think we're just in this correction period. I was just trying to provide that extra color this time to explain what I think are short-term, margin influences, but not long-term market trends.

Operator (participant)

Thank you. Our next question is from Steven Fisher with UBS. Please proceed with your question.

Steven Fisher (Managing Director and Equity Research Analyst)

Thanks. Good morning. Just curious about how much visibility you have to on-highway engine pricing, going forward at this point, you know, into 2024. I guess, to what extent is your pricing gonna be dependent on the pricing of your OEM customers, or how independent can that be?

Jennifer Rumsey (Chair and CEO)

Yeah, you know, we were price-cost favorable this year, as we've shared previously, and we have, you know, we're continuing to focus on pricing with new product launches and where we've seen inflationary costs coming through. So we're working to continue to maintain that positive price-cost ratio. And, you know, we're seeing some slowing, of course, and pricing in the market, but we'll continue to expect to have some of that.

Mark Smith (CFO)

Right. And again, when we give our for next year, then we'll, I'm sure you'll ask us about price cost. We'll be happy to share the total dynamically.

Steven Fisher (Managing Director and Equity Research Analyst)

For sure. Yes, thank you. And then just can you expand a little bit on your comments on the construction outlook? I, I think you cited inventory adjustments in North America, but maybe you can just talk about the broader global view of engine demand for construction applications and how you think the setup there is for 2024. Is there sort of a demand question, or is it just sort of near-term inventory management?

Mark Smith (CFO)

Yeah, I think part of it can be, you know, the age of construction fleets, right? So we're seeing a drop off in engine demand. That doesn't necessarily mean a dramatic shift in North America, construction activity. You know, the three biggest markets for us are North America, China, and Europe. I think generally it feels like the pace of economic growth in Europe is slowing. In China, it surprised us a little bit that the construction equipment demand hasn't fallen even further, given some of the travails, in the overall kind of financial health of the construction sector in China. But yeah, no clear picture yet going into next year, I would say. But of all the markets, that's, we still got some tire kicking to do, Steve, to figure out where we land for next year.

Operator (participant)

Thank you. Our final question will be from Noah Kaye, with Oppenheimer. Please proceed with your question.

Noah Kaye (Senior Research Analyst)

Yeah, thanks. You indicated, you know, some favorable testing around the X15N coming to market next year. Just would love to get a little bit more color on your expectations for demand there, the extent to which this could be a driver of share gains and where you're hearing the sort of the strongest indicators of demand for that product.

Jennifer Rumsey (Chair and CEO)

Yeah, so we'll launch the X15N here in North America next year. As you heard me say, it's performing well in China. We'll have a U.S. version of that, of course, meeting the regulatory requirements here next year, and we'll have availability now through two of our OEMs. And we are seeing end customers testing and interested in that product. We'll have the only heavy-duty natural gas product offered here in North America. So of course, that creates some opportunity for us as customers where they've got infrastructure, environmental goals, or even operating cost benefits associated with natural gas will start to adopt that solution more. So there's some opportunity there for sure.

Noah Kaye (Senior Research Analyst)

Okay. And then I think, you know, would love to get a catch up on the electrolyzer backlog and, you know, quoting activity. Any change in the trajectory there? Anything you noticed during the quarter, and can you update us on where you're at in terms of building out capacity?

Jennifer Rumsey (Chair and CEO)

Yeah, really on the same trajectory we've talked about previously with building up, manufacturing capacity, here in the U.S. and Europe, continuing to have, backlog growing. We are in the process of commissioning a 25 MW electrolyzer, with Florida Power & Light, over the course of this year. So another big project that we're delivering this year, and we continue to ramp up that business as we described previously.

Operator (participant)

Thank you. There are no further questions at this time. I'd like to hand the floor back over to Chris Clulow for any closing remarks.

Chris Clulow (VP of Investor Relations)

Thank you very much for your interest today, and, as always, the investor relations team will be available for calls, and answer any further questions that you may have. Thank you.

Operator (participant)

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.